Trying to understand Return on Capital (Joel Greenblatt's Magic Formula version)

Question

I'm trying to understand the Return on Capital formula, as presented in Joel Greenblatt's The Little Book that Beats the Market.

Return on Capital = EBIT / (Net Working Capital + Net Fixed Assets)

Fundamentally, I get it... You want high earnings relative to your cost of doing business. Makes sense...

However, it's in breaking down the formula where I'm getting confused. Specifically, with Net Working Capital.

Net Working Capital = Current Assets - Current Liabilities

Or Greenblatt's version

Net Working Capital = (Current Assets - Excess Cash) - (Current Liabilities - Short Term Debt)

Therefore when I tie the Net Working Capital back into the bigger Return on Capital calculation, it's beneficial to have high current liabilities in relation to current assets. How does this make sense?

Why would Net Working Capital, which is a good thing, have a negative impact on the Return on Capital calculation?

Answer 1

I've spent enough time researching this question where I feel comfortable enough providing an answer. I'll start with the high level fundamentals and work my way down to the specific question that I had.

Background

1. Greenblatt wants to find good companies
2. A good company efficiently invests its own money at a high rate of return
3. A company that efficiently invests its money at a high rate of return earns a lot of money relative to the amount of capital used to acquire profits.
4. The capital used to acquire profits, or capital employed, is the cost of fixed assets and working capital
5. Working capital is the component that provides perspective into how efficiently a company is investing its excess assets

So point #5 is really the starting point for my answer.

Evaluating Working Capital

We want to find companies that are investing their money. A good company should be reinvesting most of its excess assets so that it can make more money off of them.

If a company has too much working capital, then it is not being efficiently reinvested. That explains why excess working capital can have a negative impact on Return on Capital.

But what about the fact that current liabilities in excess of current assets has a positive impact on the Return on Capital calculation? That is a problem, period.

If current liabilities exceed current assets then the company may have a hard time meeting their short term financial obligations. This could mean borrowing more money, or it could mean something worse - like bankruptcy. If the company borrows money, then it will have to repay it in the future at higher costs. This approach could be fine if the company can invest money at a rate of return exceeding the cost of their debt, but to favor debt in the Return on Capital calculation is wrong. That scenario would skew the metric. The company has to overcome this debt.

Anyways, this is my understanding, as the amateur investor. My credibility is not even comparable to Greenblatt's credibility, so I have no business calling any part of his calculation wrong. But, in defense of my explanation, Greenblatt doesn't get into these gritty details so I don't know that he allowed current liabilities in excess of current assets to have a positive impact on his Return on Capital calculation.

Answer 2

This blog gives a good explanation of what Greenblatt considers capital employed.

There's a basic mistake in The Gilbert Arenas Dagger's explanation: Greenblatt does not include interest bearing liabilities in his definition! He subtracts liabilities which do not bear interest. Why? They are basically interest free loans! Which are good thing.

Answer 3

Why would Net Working Capital, which is a good thing, have a negative impact on the Return on Capital calculation?

Having high Net Working Capital is a good thing. Spending high Net Working Capital is a bad thing.

The idea is to calculate how much returns you are getting, divided by how much capital, due to this investment, you don't have available for other investments. The less capital you need to fund the investment, the better. The purpose of calculating Net Working Capital is not to figure out what your net worth is (which is a good thing), it's to calculate how much of your net worth is tied up in this investment (which is a bad thing). If the investment has high liabilities, then it's not your money that's tied up, it's someone else's.

Someone who's bought a business for $1,000,0000 and is making $1000 a year from it may have more money than someone who's making $1000 a year from a $10,000 investment, but the latter has a higher rate of return.

Answer 4

Just to clarify things: The Net Working Capital is the funds, the capital that will finance the everyday, the short term, operations of a company like buying raw materials, paying wages erc.

So, Net Working Capital doesn't have a negative impact. And you should not see the liabilities as beneficial per se. It's rather the fact that with smaller capital to finance the short term operations the company is able to make this EBIT. You can see it as the efficiency of the company, the smaller the net working capital the more efficient the company is (given the EBIT).

I hope you find it helpful, it's my first amswer here.

Edit: why do you say the net working capital has a negative impact?