Example 1 – Earnings Yield Calulations

From my blog 9 key concepts to understand the earnings and valuation of companies, I discussed the following example from Joel Greenblatt’s book The Little Book that beats the Market.

“For example, in the case of an office building purchased for $1 million with an $800,000 mortgage and $200,000 in equity, the price of equity is $200,000 but the enterprise value is $1 million. If the building generates EBIT (earnings before interest and taxes) of $100,000, then EBIT/EV or the pre-tax earnings yield would be 10 percent ($100,000/$1,000,000). However, the use of debt can greatly skew apparent returns from the purchase of these same assets when only the price of equity is considered. Assuming an interest rate of 6 percent on an $800,000 mortgage and a 40 percent corporate tax rate, the pre-tax earnings yield on our equity purchase price of $200,000 would appear to be 26 percent.* As debt levels change, this pre-tax earnings yield on equity would keep changing, yet the $1 million cost of the building and the $100,000 EBIT generated by that building would remain unchanged. In other words, P/E and E/P are greatly influenced by changes in debt levels and tax rates, while EBIT/EV is not.”

*$100,000 in EBIT less $48,000 in interest expense equals $52,000 in pretax income. $52,000/$200,000 equals 26 percent. The E/P (earnings/price), or after-tax earnings yield, would be 15.6 percent ($100,000 in EBIT less 48,000 in interest less $20,800 in income tax equals $31,200 in after-tax income; $31,200/$200,000 equals 15.6 percent). This 15.6 percent return ould be more comparable to looking at an EBIT/EV after-tax yield of 6 percent i.e., looking at EBIT as if fully taxed, or net operating profit after tax divided by EV; it is important to note that the fully taxed EBIT to enterprise value of percent would be the earnings yield ratio used to measure investment alternatives versus the risk-free 10-year government bond yield, not the EBIT/EV ratio of 10 percent).

Example 2 – Comparison of Corporations and Partnerships
From my blog , What is a company, what characterises a company and why form a company ?,



Limited liability for investors

Free transferability of shares (investment highly fungible)

Corporation has separate legal personality

Corporate life of indefinite duration and very stable

Centralised management

Joint and several liability of partners – potential unlimited liability for partnership’s contractual and tortious debts

Interests not freely transferable (investment relatively illiquid)

No separate legal personality

Partnership life span more fragile and precarious

Partners usually manage the business

Example 3 – How options work examples

From my blog, How To Understand Options In Only 5 Minutes From Scratch

To see how options work, let’s consider an example using a stock option. Say that you believe the price of IBM is going to rise over the next three months. But instead of buying 100 shares of IBM, you decide to buy a call option. The IBM call gives you the right, but not the obligation, to buy 100 IBM shares for a specific price until a specific point in time. For this right you pay a price: the option premium. Furthermore, you can exercise the right at any time until the option expires—that is, unless you close the position before the option expires. You can close an option position at any time through an offsetting transaction. For example, if you buy an IBM call options contract, you can close the position at any time by selling an identical IBM call options contract.

In another example, suppose you do not own any options and you agree to sell or write a call option on IBM. Why would you do this? Well, some traders sell options in order to collect the premium and earn income. However, if the stock rises dramatically, the trader may be asked to sell IBM shares to the option holder at the call strike price, which is well below the current market price.

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