Chapter 2 — Indicators of a Good Business

Digging Deeper into Johnny’s Lemon Empire

As you already know, Johnny is a tremendous businessman, and luckily for him, his business is still thriving. Johnny’s success has allowed him to expand his empire by opening new lemon stores across the country. Now, Johnny owns over 10 stores. 🍋

The Numbers Behind Johnny’s Success:

• On average, Johnny spends $100,000 to open a new lemon store.
• Each store generates $15,000 yearly in profit. 💸

Introducing Diego’s Padelmania

Diego is also a businessman (it seems that entrepreneurial spirit runs in the family!). However, Diego’s business is very different from Johnny’s. Diego is capitalizing on a rapidly growing sport called padel by building courts and renting them out to customers. 🎾

The Numbers Behind Diego’s Venture:

• Each padel court costs Diego $160,000 to build.
• On average, each court generates $40,000 yearly in profit. 🌟

Comparing Johnny’s Empire vs. Diego’s Courts

Good news! You’re also a businessman. Johnny's business is generating $15,000 profit per store per year while Diego's court generates $40,000. But it's way cheaper to open a lemon store. 🤔

What if we compare 2 lemon stores with 1 of Diego's courts? Or analyze what happens if profits drop by 30%? Let’s break it down! ✌️

Johnny’s 2 Stores vs Diego’s Court

Diego’s Court:

• Total investment: $160,000
• Total yearly profit: $40,000

Johnny’s 2 Stores:

• Total investment: $200,000
• Total yearly profit: $30,000

What Happens if Profits Drop by 30%?

Johnny’s Lemon Empire:

• New profit per store: $10,500
• Return on capital per store: 10.5% 🤔

Diego’s Padelmania:

• New profit per court: $28,000
• Return on capital per court: 17.5%

What Does This Mean? 🌟

1. Diego's business generates more money with less investment. His product is rarer and more valued.
2. Johnny's business is less resilient when profits decline, but Diego's business remains profitable.

Return on Capital (ROC): A Key Indicator

What is return on capital? Return on capital (ROC) measures how effectively a business uses its money to generate profits. The examples above used a simplified Profit ÷ Investment to build the intuition. Joel Greenblatt's actual formula, from The Little Book That Beats the Market — and the one the tool below computes — refines this a bit, so let's break it down piece by piece:

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

• EBIT stands for "earnings before interest and taxes" — basically, the profit the business makes from actually running its operations, before we count things like loan interest or the tax bill. We use this instead of plain profit so that two identical businesses get the same score even if one of them happens to have more debt or a different tax rate. It's a way of judging the business itself, not how it's financed.
• Net Working Capital + Net Fixed Assets is our way of estimating how much money is actually tied up in running the business day to day — things like inventory and equipment — rather than cash just sitting in the bank or the extra price paid for a past acquisition. Cash in the bank and "goodwill" from acquisitions don't help the business make next year's profit, so we leave them out to get a fairer picture of how hard the company's real, working capital is working for it.

How High Is High Enough?

Greenblatt never fixes a single passing grade, and he's right not to — how much capital a business needs varies enormously from one industry to another. But you still need somewhere to start, so here's the bar the tool below uses:

| Return on capital | What it suggests | | --- | :--- | | 30% or more | Strong. The business turns a lot of profit from very little tied-up money. | | 15% to 30% | Adequate. Respectable, but not what sets a business apart. | | Below 15% | Capital-hungry. Every extra dollar of profit takes a lot of money to produce. |

Why is the bar so high? Because a listed company is not a padel court. 🎾 Diego has to build each new court before it earns him anything, and Johnny has to stock each new lemon store. Plenty of businesses you can buy on the stock market barely work that way at all: a software company that bills its customers a year in advance, or a payments network that runs on servers rather than real estate, can grow without tying up much of anything. Once you start screening real companies you'll find that clearing 15% is common, so a bar set there stops telling you very much. Thirty percent is where the genuinely capital-light businesses start to separate themselves.

You'll occasionally meet a business where the tool prints no percentage at all and calls the result capital-free. That is not missing data — it means the capital tied up in the business is negative, because customers pay before they're served. That's the best outcome this measure can produce, and we'll come back to it when you meet one.

Which Business Would You Invest In?

• A. A business that has higher earnings yield (from Chapter 1).
• B. A business with a high return on capital.
• C. Both A and B.

🔍 Getting it Real!

It's fun to play with imaginary businesses like Johnny's Lemon Empire and Diego's Padelmania, but isn't it more fun to look at real businesses? Let’s get down to it!

Explored metrics:

• EBIT
• Net Working Capital
• Net Fixed Assets
• Invested Capital
• Return on Capital

If digging through financial reports feels overwhelming, don’t worry. Use the tool below to explore your favorite companies and find the magic in the market.

Next Steps

Now that we’ve cracked the code for spotting bargains 🏷️ and identifying great businesses 💼, it’s time to move forward with purpose! Here’s what’s coming next:

• Combine the Strategies: Merge what you’ve learned into a single, powerful methodology.
• Prove It Works: Test this approach with historical data and real-world scenarios.
• Discover Today’s Winners: Apply the magic formula to find the best businesses to invest in now.

The strategies are in place, and the tools are ready. Now it’s your time to act—get ready to unlock the secrets of successful investing!

Let’s go to Chapter 3 and build the ultimate strategy! 🚀