Maybe there’s an earnings based valuation ratio that gives a good indication of the theoretical return from an investment and is suitable for comparing one company’s market valuation with another.

I thought I had it when I adopted Joel Greenblatt’s definition of the earnings yield: EBIT/EV.

The rationale for using Earnings Before Interest and Tax instead of the post-tax figure used in the PE ratio and traditional earnings yield, and Enterprise Value instead of market capitalisation, is to factor the cost of repaying debt into the price and exclude interest from the profit, because debt distorts the PE.

To turn it into the yield a shareholder might receive, I tax EBIT at the prevailing rate (24%).

You could call my measure EBI/EV. I called it the unlevered earnings yield.

Then the Human Screen dug up Advanced Computer Software, a company that has grown rapidly through acquisition. This is its EBI:

EV = market capitalisation (''197.8m) + net debt (''1.2m) = ''199m

EBI = EBIT (profit from continuing operations: ''8.1m)*(100-24)% = ''6.2m

EBI/EV = 3%

The earnings yield is just 3%.

But, bearing down on Advanced’s profit is a massive ''12.8m charge for the amortisation of acquired intangibles, an expense incurred when it took over various companies. Since this amortisation has no bearing on future earnings, I think we should ignore it, which means adding it back to operating profit or EBIT to make EBITA (Earnings Before Interest, Tax and Amortisation (of acquired intangibles)).

Advanced’s EBITA is:

EBITA = 8.1+12.8 = ''20.9m

Which is more representative of its earning power.

Deduct interest and you get EBIA, which is a fantastic achievement: an earnings based acryonym that hasn’t yet been coined!

EBIA = 20.9*(100-24)% = ''15.9m

So…

EBIA/EV = 8%

An earnings yield of 8% is not obviously cheap, but it’s a lot better than 3%, I might invest if I was convinced the company would grow.

Problems:

• No-one will understand my acronym.
• Although Wexboy’s in a broad agreement about adding back acquired intangibles, so’s theredcorner and LolTradez, Philip O’Sullivan would have me ignore depreciation by adding it back too, and Neonomic suggests adding back capital expenditure instead of depreciation.

While ignoring depreciation would get around the problem that companies depreciate similar assets at different rates, ignoring it also flatters capital intensive industries. Unlike the amortisation of acquired intangibles, depreciation, if correctly calculated) is a recurring cost, the necessary cost of capital expenditure if the business is to continue operating at the same scale (actually, as IMHO says, it’s a hint of minimum capital expenditure), so, even though depreciation can be manipulated, I think it should be included in comparisons between companies, and when computing an earnings yield.

The inestimable Geoff Gannon is an EBITDA fan though.