This screen was designed by the MFIE Capital team in 2010 and reveals companies with consistent earnings power for which the shares are trading at a considerable margin of safety. It can be seen as an extension of the Greenblatt Magic Formula as it uses the same calculation method and shares 2 ratios with the latter. The big difference is that it looks for companies that trade at a discount compared to book value and filters out companies that showed exceptional results during the last year. We made this screen available to all our users since it showed superior performance in our backtest.
“Our ERP5 screen generated a return of 18,66% annually in the period 1999-2010. By filtering out companies with an f-score less than 7, the return increased to 19,5% per annum.”
How does it work?
We rank companies based on 4 ratios:
- Earnings Yield (EY):
EBIT/Enterprise Value. This compares the earnings of a company compared to its theoretical purchase price. (market capitalization + debt) A company with a high EY can be purchased at a relatively low price compared to the earnings it generated during the last 12 months.
- Return On Invested Capital (ROIC):
EBIT / (Net Working Capital + Net Fixed Assets). A company with a high ROIC demonstrates that it's lean, i.e. it's able to generate high earnings compared to the money invested.
- 5 year ROIC:
Average ROIC during the last 5 years. Has the company demonstrated that it's been able to generate relatively high returns in a consistent manner in the past.
Market Cap/Common Shareholders Equity. How big is the margin of safety, i.e. the price you pay for a share compared to the book value of the company. Research shows that buying companies with a low price-to-book value generates superior returns. (e.g., Rosenberg, Reid-, and Lanstein 1984; Fama and French 1992; and Lakonishok, Shleifer, and Vishny 1994)
We rank each company on these 4 ratios and then sum up the rankings. We rank this score to get the ERP5 score.
We created a variation of this screen and named it the ERP5 Best Selection. This screen ranks the companies based on ERP5 score but also filters out ones with an f-score of less than 7. This way we only select companies for which the prospects are improving compared to last year. Adding this extra filter increased the yearly return in our 1999-2010 backtest by almost 1%, from 18,66% to 19,5%.
In our glossary:
Book-to-Market RatioA ratio used to find the value of a company by comparing the book value of a firm to its market value. more...
Return on Capital (ROC)Return On Capital (ROC) measures a company's efficiency at allocating the capital under its control to profitable investments. more...
Earnings YieldThe standard definition of earnings yield is the earnings per share divided by the price of a share. more...
ERP5The ERP5 score was designed by the MFIE Capital team. more...
ROC 5YFor similar reasons as for the Earnings Yield 5Y, this ratio smooths the ROICs of the last 5 years to smooth out business and economic cycle, as well as price fluctuations. more...
In our blog:
ERP5 Best Selection backtesting results available!We just completed backtests on our ERP5 Best Selection screener using our proprietary backtesting tool. more...
Which magic formula is the most popular<small>(Intro from the June 2014 edition of the systematic value investor newsletter)</small></p> Over the past 5 years we gathered quite a few screens and ratios. more...
In our paper3:
ERP5The ERP5 rank is a screen designed by MFIE Capital that uses the following ratios to identify good companies that are trading at undervalued prices:</p> <ul> <li>Return on Invested Capital (ROIC) - EBIT / (Net Working Capital + Net Fixed Assets). more...
ERP5With this combination we combined the 20% of companies with the highest ERP5-rank with all the second factors we tested. more...