Return on Capital ('ROC') is measured by taking a company’s pre-tax operating earnings ('EBIT') and dividing it by tangible capital employed; the higher the ratio the better. Joel uses ROC instead of the more commonly used Return on Equity (ROE = earnings/equity) or Return on Assets (ROA = earnings/assets) because ROC uses earnings before interest and taxes. Joel’s reasoning is that different companies operate with different levels of debt and differing tax rates.
Earnings Yield is measured by taking a company’s pre-tax operating earnings ("EBIT") and dividing it by Enterprise Value (Market Value of equity + Net Interest Bearing Debt). Joel uses Earnings Yield instead of the more commonly used Price/Earnings (P/E) ratio or Earnings/Price (E/P) ratio because P/E and E/P are greatly influenced by debt levels and tax rates, while Earnings Yield is not.
In layman’s terms ROC helps you measure how much income a business is earning in relationship to how much it costs. A business with a high ROC means it can invest its own money into the business with a high rate of return. Earnings Yield helps you find a company that earns more compared to price you are paying for it.
Using Joel’s criteria, I screened for companies with a minimum market capitalization of $500 million, a high ROC and a high Earnings Yield. Looking at the top 100 companies that met this criteria, I found one lone gold mining stock, Northgate Minerals Corp. (NXG). Northgate’s ROC is in the 25-50% range, and the Earnings Yield is 17%. Northgate appears to be worth serious consideration, and may be the next gold mining gem using Joel’s criteria.
Joel Greenblatt is the author of The Little Book that Beats the Market. In the book he discusses in detail, the advantages and strategies of using ROC and Earnings Yield to evaluate a stock investment. I highly recommended reading the book as it offers a simple and well reasoned approach to finding potentially undervalued investments.
NXG 4-yr Daily Chart