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return on capital Joel Greenblatt with the magic formula uses return on capital as one of the two metrics he used to screen companies and return on capital is really a measure of how good business is it's one of the most powerful metrics to find companies that are gonna be long-term compounders for you which obviously works wonders for your portfolio over the long term so today I want to run through an example of how to calculate return on capital as Joel Greenblatt calculates it for the magic formula there's many ways to calculate return on capital but I want to go through specifically how he calculates it so let's quickly take a look at what the formula for return on capital is that Joel Greenblatt uses this is really you know return on tangible capital employed okay so return on capital pre-tax operating earnings also known as earnings before interest in taxes Abbott divided by tangible capital employed now you know don't be intimidated by this you know there's probably gonna be a lot of new terms here for you everything seems intimidating when it's new but this really isn't super comp complicated so just take a moment to sit with it and run through the formula a few times with different companies and you'll you'll start to understand and why this is a really useful formula tangible capital employed which is the denominator in the return on capital is simply net working capital plus net fixed assets now the net working capital part of that is just total current assets minus total current liabilities okay and you're going to add that to net fixed assets which on the balance sheet is simply total net property plant and equipment that's gross property plant and equipment minus depreciation costs so let's do an example for Apple okay so I'm in Morningstar I mean Apple I'm gonna go to financials and I'm gonna scroll down to let's see I want the tables version now that Evatt number that you saw is simply operating income that's earnings before interest and taxes so I'm gonna use the trailing 12 months number sixty five point five nine billion dollars okay so that's gonna be right here that's going to be our Abbott sixty five point five nine now I need to find net working capital which is total current assets and for that I'm going to click on this balance sheet right here it's just showing us a couple of categories within the balance sheet but I'm gonna want some more specific categories so I got to click on that now I'm gonna scroll over I want the quarterly numbers so looking at quarter to 2020 I want to make this a little wider so I can see what's happening I'm gonna scroll down let's see and I'm looking for total current assets for quarter two of twenty twenty we've got one forty three point seven five billion dollars so I'm going to put that here one forty three point seven five that's my total current assets now I want to find my total current liabilities so that is now we're in the total liabilities section total current liabilities ninety six point oh nine billion okay so I'm gonna subtract that from one forty three point seven five and then I'm going to add the net fixed assets so let's come back into here I'm gonna come up under the assets and I'm gonna look at so here's my total gross property plant and equipment like I said I want to remove the depreciation and I've got total net property plant and equipment so that's my net fixed assets thirty five point eight nine billion okay so when I run the math here on this formula I get a return on capital of seventy eight point five percent for for Apple now that's an insanely high return on capital this is a fantastic business in terms of return on capital just for comparison Costco I ran the numbers has about nineteen percent in terms of return on capital and Costco's a phenomenal business so really anything over twenty twenty five percent is is a strong return on capital especially if you're looking back five or ten years and it has a consistent return of capital over twenty percent so but this is insane for Apple seventy eight point five percent so I just wanted to give that overview I'm gonna read from the appendix in this book by Joel Greenblatt the little book that still beats the market just why he uses these particular metrics for calculating return on capital and it's just a little blurb in the appendix about why he uses the particular method so he says return on capital was measured by calculating the ratio of pre-tax operating earnings which is abot to tangible capital employed net working capital plus net fixed assets this ratio was used rather than the more commonly used ratios of return on equity or return on assets for several reasons Abbott or earnings before interest in taxes was used in place of reported earnings because companies operate with different levels of debt and differing tax rates using operating earnings before interest and taxes allowed us to view and compare the operating operating earnings of different companies without the distortions arising from differences in tax rates and debt levels for each company it was then possible to compare actual earnings from operations Abbott to the cost of the assets used to produce those earnings which is tangible capital employed net working capital plus net fixed assets or tangible capital employed was used in place of total assets or equity the idea here was to figure out how much capital is actually needed to conduct the company's business net working capital was used because a company has to fund its receivables and inventory but does not have to lay out money for its payables as these are effectively an interest-free loan in addition to working capital requirements a company must also fund the purchase of fixed assets necessary to conduct its business such as real estate plant and equipment the depreciated net cost of these fixed assets was then added to the net working capital requirements already calculated to arrive at an estimate for tangible capital employed so that's from Greenblatt's book and one of the great things about Greenblatt you know he ran a fund for I think 20 years and that fund generated 40% annual returns for 20 years which you know even starting with a small number if you're getting 40% returns for 20 years I mean it's just insane how large growth that is and one of the things he spent a lot of money back testing how you know different metrics correlated with of stock returns and so this particular way of calculating return on capital you know he put a lot of thought and a lot of data is behind kind of this this approach for calculating return on capital obviously just a brilliant investor I highly recommend you know checking out videos from him on YouTube reading his books he has multiple books out on investing in the stock market so yeah I just wanted to quickly run through how Joel Greenblatt calculates return on capital in the magic formula investing approach I'll probably do another one of these videos to kind of walk through how he calculates earnings yield which is the other metric and it's really a measure of how cheap a business is because what he found is when you combine a metric for how good a business is with how cheap a business is that combined kind of ranking is really what drives the magic formula investment screener and it's it's proven to be a great way to kind of screen stocks to find stocks that are both good and cheap which is really how Buffett and Munger through Berkshire Hathaway and other great value investors have you know because I've grown their portfolios to be so large by finding businesses that are both good and cheap so I just wanted to introduce return on capital let me let me know if you guys have any questions about return on capital in the comments I made a video a couple days ago about invisible motes or hidden motes it was a based on a blog post from chris meyer who wrote a book called 100 baggers stocks that returned 100 to 1 and how to find them and return on capital was you know the most kind of important metric for finding companies that have moats either obvious moats like Amazon Apple Microsoft or hidden moats which you know when you find companies that have hidden moats often you can get them for a much lower price which is obviously a very important part of the equation for finding great long-term investments so anyway guys that's all I got for today smash that thumbs up if you enjoyed this video hit that subscribe button I am over a thousand subscribers obviously but I'm still you know still trying to grow the channel and really hit that four thousand watch our metric that is the other metric that I need in order to start monetizing the channel but that's all I got guys I will see you in the next video take care
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