There appears to be an inconsistency in Table 1 of “The Magic Formula Approach to Stockpicking” article in the January/February 2006 issue [which presents a stock screen based on Joel Greenblatt’s recent book, “The Little Book That Beats the Market”]. I do not think that the amount used in the example for “excess cash” agrees with the footnoted definition. The amount used in the example is $340.3, which is the amount of short-term investments. The footnote indicates that “excess cash” is the sum of cash and short-term investments. This amount is $340.3 + $216.0 = $556.3

What is the correct definition, and what is the correct amount?

—L.J.

CI Editor Responds: Both the definition and example in the table are correct. Cash of $216.0 and short-term investments of $340.3 are used to reduce the enterprise value. The equation for enterprise value is market cap + interest-bearing debt – excess cash. For our example:

Market cap is $3,680.4,
Interest-bearing debt is $0.0
Excess cash is $216.0 (cash & equivialents) and $340.3 (short-term investments)

One could write the equation a number of ways:
$3,680.4 + $0.0 – $216.0 – $340.3, as shown in Table 1, or
$3,680.4 + $0.0 – ($216.0 + $340.3)

Either way, the end result is the same:
$3,680.4 – $216.0 – $340.3 = $3,124.1
$3,680.4 – $556.3 = $3,124.1

Table 1. Greenblatt's Calculations: An Example CLICK ON IMAGE TO SEE FULL SIZE.

In the article “The Magic Formula Approach to Stockpicking,” Table 1 (see right) demonstrates a calculation for net working capital. It indicates as part of the input a “cash for business” value of $0.0—used when the cash is zero or negative. The balance sheet indicates cash & equivalents as $216.0. How is it that the cash for business value is assigned $0.0?

—W.S.

CI Editor Responds: The key is to break down the cash between “cash for business” and “excess cash.” For our example, we allocated all of the cash ($216.0 million) as excess cash. Therefore, none of the cash was allocated toward cash for business. The excess cash was then used for the determination of enterprise value. If one could determine how much of the cash was needed for normal day-to-day operation, then you would split the cash allocation between the two proper sections. In this, case, we are unable to make that distinction.