In part I of this mini-series, MagicDiligence defined what goodwill is and how it is accounted for on the balance sheets of public companies. In this second part, we'll take a look at the ramifications of goodwill accounting towards the Magic Formula Investing strategy devised by Joel Greenblatt in The Little Book that Beats the Market.
To do this, let's first quickly review the screening method used by Magic Formula Investing. There are two variables. The first is earnings yield, which is a modified valuation statistic similar to the P/E ratio. It measures how cheap a stock is relative to trailing earnings. The second variable is return on invested capital, which measures the return a company earns on the money it invests into the business. All non-financial and non-utility U.S. traded stocks are scored on these two variables and ranked from highest to lowest on each. The rankings are then added together and, voila!, the MFI screens are created. The idea is that the highest ranked stocks are the best businesses (highest returns on capital) at the cheapest prices (highest earnings yield) available on the market today.
It's the second variable, return on invested capital, that we'll focus on here. Traditionally, return on invested capital measures the post-tax profit earned on net assets used in running the business, not including "extra" assets like excess cash and investments (more details in this article). However, Greenblatt made a few modifications to the MFI return on capital calculation to account for what he perceived as misleading differences between businesses:
1) MFI uses pre-tax operating earnings instead of post-tax. The reason for this is to remove the differences in tax rates between different businesses. For example, a company like Resources Global Professionals (NASDAQ:RECN) that does the majority of business in the United States pays a tax rate over 40%, while a company like Western Digital (NYSE:WDC), who generates most earnings and pays most costs in Asia, pays a tax rate in the single digits. By removing tax effects, you get a better picture of the efficiency of the business itself, without being skewed by non-operating related aspects.
2) MFI removes intangible assets and goodwill from invested capital. Greenblatt believes that intangible assets represent a balance sheet value that is difficult to measure - who knows what a brand or patent protection is really worth? And, in any case, internally developed intangible assets, like Coke's (NYSE:KO) brand name or Pfizer's (NYSE:PFE) patents have no balance sheet value at all! Only acquired intangibles can be included. Therefore, to account for the inconsistencies in comparison between different companies, the values are just removed entirely.
The effect of MFI return on capital is to produce a number that is not really meaningful on a stand-alone basis, but is useful for comparing businesses. While a "normal" ROIC of 20% is meaningful - any asset producing 20% returns a year is very valuable! - a MFI return on capital figure is purely relative and doesn't mean anything in a vacuum. The benefits of the modifications are that the MFI screen is truly comparing the efficiency of invested tangible assets between businesses. The best businesses, those that need little tangible capital to produce earnings and earn high returns on what is employed, invariably rise to the top.
However, there are downsides as well. First, tax effects are real - taxes paid reduce the cash flow that can be reinvested in the business or distributed to shareholders. For every dollar of Western Digital's operating earnings, over 0.90 belongs to the shareholders, while only about 0.60 of Resources Global falls to the bottom line, an important point.
Perhaps even more important are the ramifications of removing goodwill and acquired intangible assets from the return on capital calculation. In effect, this removes any penalty for companies that overpay for acquisitions as a strategy for growing sales. A company can drastically overpay for the assets of a business, and the overpayment is tucked away in a goodwill account that MFI simply ignores. Several MFI stocks are companies that have a history of growing by acquisition, and overpaying for those acquisitions. This can be seen when the MFI return on capital number is very good (say, over 80%), but the traditional ROIC calculation is average or worse (15% or less). Let's use the familiar example of eBay (NASDAQ:EBAY) and its textbook "overpay for acquisition" purchase of Skype.
Quickly, here are the normal ROIC and Magic Formula ROIC calculations for eBay for the year ended in 2006, before Skype was written down:
Normal ROIC = (Operating Earnings * (1 - Tax Rate)) / Invested Capital = (1.42B * (1 - 27%)) / 8.3B = 12.6%
MFI ROIC = (Operating Earnings) / (Invested Capital - Goodwill+Intangibles) = 1.42B / (8.3B - 7.3B) = 140%
That's quite a difference! The standard ROIC shows a company earning a pretty mediocre return on capital, while the MFI figure is top tier. MFI ignored over 7 billion dollars of shareholder capital that was used to purchase businesses in the past! A lot of that $7 billion could have been returned to owners in the form of dividends or share repurchases instead of blown on non-core business like Skype. Fortunately for eBay shareholders, new management has written down the original $2.5 billion dollar investment and plans to IPO Skype, returning to investing capital in eBay's outstanding core businesses like Paypal and Marketplaces.
When MagicDiligence analyzes stocks for the Top Buys portfolio, discrepancies like this are duly noted and investigated. We do not want to buy into management teams more interested in building empires than earning high returns on our invested dollars.
Disclosure: Steve owns PFE, EBAY