EYATH (Earnings Yield Adjusted for Tangible Health)

• The Bottom Line: EYATH is a value investor's custom tool that stress-tests a company's earnings yield by penalizing it for having a weak balance sheet loaded with debt and intangible assets.
• Key Takeaways:
  • What it is: A proprietary metric that starts with the standard earnings_yield and then adjusts it downwards based on the proportion of debt and intangible assets (like goodwill) a company holds.
  • Why it matters: It provides a more conservative and realistic picture of a company's earning power, helping you avoid businesses whose profits are built on a shaky foundation. It's a direct application of the margin_of_safety principle.
  • How to use it: Use EYATH to compare companies, especially within the same industry, to quickly identify which ones have high-quality earnings backed by a robust, tangible balance sheet.

Imagine you're buying a used car. Two cars are for sale at the same price, and both sellers claim their car has 300 horsepower. The first car is a well-maintained sedan with a solid engine block and a strong steel frame. The second car is a flashy sports car, but you discover much of its “power” comes from a temporary chemical booster, and its frame is held together with questionable welds from a past accident. Which car is the better long-term investment? Obviously, the first one. The horsepower is real and durable. EYATH (Earnings Yield Adjusted for Tangible Health) is the financial equivalent of looking under the hood. While the standard P/E Ratio or its inverse, the earnings_yield, tells you about the engine's stated horsepower (the profits), EYATH goes a step further. It inspects the “chassis” – the company's balance_sheet – to see how much of that power is supported by a solid frame of tangible assets versus a rickety structure of debt and “air” (intangible assets like goodwill). In simple terms, EYATH takes the company's earnings yield and discounts it to account for two major risks beloved by speculative companies and hated by value investors:

1. **Excessive Debt:** Debt is a fixed claim on a company's future earnings. Too much of it can bankrupt an otherwise good business.
2. **Intangible "Fluff":** When one company buys another for more than its assets are worth, the difference is booked as "goodwill." While some intangibles are valuable (like patents), goodwill can often represent overpayment and can be written down to zero if the acquisition sours.

A high EYATH suggests a company is not only profitable but also financially sound and built on a foundation of real, hard assets.

“The first rule of compounding: Never interrupt it unnecessarily.” - Charlie Munger
¹⁾

Value investing is about buying wonderful companies at fair prices, and a “wonderful company” is almost always a financially resilient one. EYATH is a powerful lens for identifying this resilience because it aligns perfectly with core value investing principles.

• It Enforces a Margin of Safety: By penalizing debt and intangible assets, EYATH automatically builds a margin_of_safety into your analysis. You are systematically favoring companies that are less likely to blow up in a recession. A company with low debt and tangible assets has more staying power and more options during tough times.
• It Prioritizes Substance Over Hype: The stock market often gets excited about companies that grow rapidly by acquiring other businesses. This strategy frequently loads up the balance sheet with goodwill and debt. EYATH cuts through the hype, asking the crucial question: “Are these earnings backed by a solid business, or are they the temporary result of financial engineering?”
• It Complements Benjamin Graham's “Net-Net” Philosophy: While not as strict as a net-net calculation, EYATH shares its spirit. It emphasizes the “tangible” part of a business. Graham famously distrusted earnings that weren't supported by a strong asset base. He knew that assets provide a floor for a company's value, while earnings can be volatile and sometimes misleading.
• It Helps You Think Like a Business Owner: If you were buying a whole business, not just a share of stock, you would absolutely scrutinize its debts and the quality of its assets. You would want to know what you actually own. EYATH forces you into this prudent, business-owner mindset.

Ultimately, EYATH helps a value investor distinguish between a cheap stock and a “value trap.” A value trap often looks cheap based on its P/E ratio but has a terrible balance sheet waiting to spring on unsuspecting investors. EYATH helps you spot the trap before you step in it.

The beauty of EYATH is its straightforward, two-step logic. First, we find the earnings yield. Second, we create a “Balance Sheet Quality” score to adjust it.

The formula can be broken down into three simple parts:

1. Part 1: Calculate the Earnings Yield (EY)

> Earnings Yield = Net Income / Market Capitalization

  > ((This is the inverse of the P/E ratio. For example, a P/E of 20 is an Earnings Yield of 1/20, or 5%.))
- **Part 2: Calculate the Balance Sheet Adjustment Factor (BSAF)**
  > BSAF = (1 - (Goodwill & Intangibles / Total Assets)) * (1 - (Total Debt / Total Assets))
  > ((This factor will be a number between 0 and 1. A perfect balance sheet with no debt and no intangibles would have a BSAF of 1. A company with high debt and/or high intangibles will have a BSAF closer to 0.))
- **Part 3: Calculate EYATH**
  > **EYATH = Earnings Yield * Balance Sheet Adjustment Factor**

The final EYATH number is a percentage that represents the company's “balance-sheet-adjusted” earnings yield.

• Higher is Better: A higher EYATH signifies a more attractive investment from a risk-adjusted perspective. An EYATH of 10% is far superior to one of 3%.
• The EYATH-to-EY Gap: The most powerful insight comes from comparing a company's EYATH to its unadjusted Earnings Yield.
  • Small Gap: (e.g., EY = 8%, EYATH = 7.5%) This indicates a strong company. Its earnings are backed by a solid balance sheet. This is the kind of business value investors love to find.
  • Large Gap: (e.g., EY = 8%, EYATH = 3.5%) This is a major red flag. It tells you the company's attractive earnings yield is undermined by a risky balance sheet. The company may be a “serial acquirer” or is using excessive leverage to generate profits.
• Compare with the “Risk-Free” Rate: Just like with earnings yield, you can compare EYATH to the yield on government bonds. If a company's EYATH is 9% while a 10-year treasury bond yields 4%, you are being paid a significant premium for taking on the additional risk of owning a business. This is the essence of rational investing.

Let's compare two fictional companies, “Steady Industrial Co.” and “Aggressive Growth Inc.” Both have the exact same Net Income and Market Cap, making them look identical on a simple P/E basis.

Based on P/E or Earnings Yield alone, they are indistinguishable. Now, let's apply the EYATH formula. Step 1: Calculate the Balance Sheet Adjustment Factor (BSAF)

• Steady Industrial Co.:
  • Intangibles/Assets Ratio = $50m / $800m = 6.25%
  • Debt/Assets Ratio = $100m / $800m = 12.5%
  • BSAF = (1 - 0.0625) * (1 - 0.125) = 0.9375 * 0.875 = 0.82
• Aggressive Growth Inc.:
  • Intangibles/Assets Ratio = $600m / $1,200m = 50%
  • Debt/Assets Ratio = $700m / $1,200m = 58.3%
  • BSAF = (1 - 0.50) * (1 - 0.583) = 0.50 * 0.417 = 0.21

Step 2: Calculate the Final EYATH

• Steady Industrial Co. EYATH:
  • 10.0% (Earnings Yield) * 0.82 (BSAF) = 8.2%
• Aggressive Growth Inc. EYATH:
  • 10.0% (Earnings Yield) * 0.21 (BSAF) = 2.1%

Conclusion: The EYATH calculation reveals the truth. Steady Industrial's profits are high-quality, supported by a rock-solid balance sheet. Aggressive Growth, despite its appealing P/E ratio, is a house of cards, with profits built on a mountain of debt and accounting goodwill from overpriced acquisitions. A value investor would immediately favor Steady Industrial and investigate Aggressive Growth with extreme skepticism.

• Focus on Quality: It forces you to look beyond the income statement and assess the financial health and durability of the business.
• Risk-Averse: It naturally filters out companies that use excessive financial leverage or risky acquisition strategies, steering you toward more conservative investments.
• Simple & Intuitive: The concept is easy to grasp: “real earnings backed by real assets.” The calculation uses readily available numbers from a company's financial statements.

• Penalizes Asset-Light Businesses: The formula can unfairly punish fantastic businesses that don't require many tangible assets. Companies with powerful brands (like Coca-Cola) or network effects (like Google) have immensely valuable intangible assets that EYATH treats with suspicion. It is best used for comparing companies within the same industry (e.g., comparing two industrial manufacturers).
• Not a Standalone Metric: EYATH is a screening tool and a red-flag indicator, not a complete valuation method. It should always be used alongside a deeper analysis of the business's competitive advantages (economic_moat), management quality, and future growth prospects.
• Ignores “Good” Intangibles: It lumps all intangibles together. A critical patent is far more valuable and durable than accounting goodwill from an overpriced merger. The analyst must still use their judgment.

• earnings_yield
• margin_of_safety
• balance_sheet
• tangible_book_value
• price_to_book_ratio
• goodwill
• debt_to_equity_ratio