Whether you're new to investing or an old hand, discovering new investment techniques is always interesting and can be enlightening.
One strategy which made waves back in 2006 for its simplicity and ability to outperform the market over the long-term was Joel Greenblatt's "magic formula investing." The formula Greenblatt utilises contains just two metrics as the core components for helping him pick stocks. Here we will simply use these two metrics to compare Origin Energy Limited (ASX: ORG) with Telstra Corporation Ltd (ASX: TLS).
The first metric is Earnings Yield. In its simplest state an earnings yield can be determined by simply taking the inverse of the price-to-earnings ratio, however to adjust for debt Greenblatt recommends using earnings before interest and tax (EBIT) dividend by enterprise value (EV). [EV is calculated by summing the market capitalisation with the net debt].
Greenblatt's yield method incorporates debt into the picture, however for investors looking for a shortcut, simply inverting the PE will give a reasonable approximation – so long as you focus on quality businesses with strong balance sheets.
The earnings yield essentially tells you what the business earns relative to the price you are paying. For example, based on data supplied by Morningstar, Origin Energy Limited (ASX: ORG) currently trades on an earnings yield of 4.7%, while Telstra Corporation Ltd (ASX: TLS) has an earnings yield of 5.9%.
The second metric which Greenblatt utilises is Return on Capital. The aim here is to determine the quality of a business – the higher the return, the better.
As a proxy investors may prefer to use Return on Equity (ROE) as most brokers compute this figure amongst company financial data provided to clients. In the case of Origin and Telstra, ROE of 5.7% and 30.2% respectively were achieved at their most recent full year results.
Pulling the formula together
As a final step, Greenblatt looks to rank stocks based on their combination of earnings yield and return on capital. In this particular case, Telstra would appear to be the more appealing investment option based on its relative price to value – as determined by earnings yield – and based on quality – as determined by return on equity.