ITT Educational Services, Inc. (NYSE:ESI) - the for-profit educational services company - has both high profitability- and low price-ratios. This is a desirable combination which is hard to find in investment opportunities. Hedge fund manager Joel Greenblatt applies these two characteristics when implementing a strategy he calls the Magic Formula®. Greenblatt's goal is to quantitatively find investments which meet Warren Buffett's principle of: buying good companies at bargain prices.
The formula quantifies good companies by measuring a firm's return on capital. It defines bargain prices as a high earnings yield. Return on capital shows how efficiently a company is with its income-producing assets, and the earnings yield projects the profit that the company will receive in relation to the price paid for the stock. At $2.95/share, ESI is currently ranking very high in both categories.
The Magic Formula® calculates earnings yield and return on capital in the following ways:
- Earnings Yield = EBIT / Enterprise Value
- Return on Capital = EBIT / (Net Property, Plant, & Equipment + Net Working Capital)
*EBIT: Earnings Before Interest & Taxes
*Enterprise Value = (Market Cap + Total Debt + Minority Interest + Preferred Stock) - Cash, Cash Equivalents, and Short-term Investments
Here is a breakdown of ESI's fundamentals and how they fit into the Magic Formula® equation:
Earnings Yield: $86,418,000 / $155,551,630 = 55.6%
- EBIT: $86,418,000
- Enterprise Value: $155,551,630
Return on Capital: $86,418,000 / ($148,606,000 + $-101,539,000) = 183.6%
- EBIT: $86,418,000
- Net Property Plant & Equipment: $148,606,000
- Net Working Capital: $-101,539,000
Using the Magic Formula® calculations, ESI has an earning's yield of 56% and a return on capital of 184%. This implies that an investor can expect the company's annual profits to be 56% of its current stock price. The 184% return on capital means that over the last four quarters, ESI's profits were 184% of the total capital invested in the firm's operations after subtracting current liabilities and accounting for depreciation.
Clearly, the market expects ESI's future earnings to be less than they were over the last four quarters. The stock would not be priced as low as it is otherwise. Greenblatt makes it clear that this shouldn't stop an investor from buying. In his book, The Little Book That Beats The Market, he explains that the Magic Formula® only works if investors avoid making predictions regarding which qualifying stocks will be profitable and which will fail.
To convey the truth of this, he told a story of a time when he passed on a stock out because he was certain its earnings would drop significantly. Shortly after, the stock was acquired by a competitor for many times the price he could have invested at. The lesson is that you never know what will happen to a specific company. There will always be a reason to pass on a bargain stock, but investing in a diversified group of Magic Formula® stocks similar as ESI has proven to be a profitable approach for disciplined investors.
At the time of this writing, ESI is displaying as a stock with a top Magic Formula® rank on TheStockMarketBluprint.com.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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