The Faustmann Ratio came from forestry. A German forester in 1849 worked out the answer one practical question. When is the right time to cut down a tree?
In 2013, hedge fund manager Mark Spitznagel applied the same logic to stocks in his book The Dao of Capital. The idea is simple. The real value of a great business comes from its ability to reinvest earnings at high rates of return for many years.
This article shows you what the ratio means, how to use a practical version of it, and how to find these companies in the Quant Investing screener.
Where the Faustmann Ratio came from
Martin Faustmann was a German forester. He published his formula in 1849 to value timber plantations. His problem was practical. If you cut a tree today, you get the timber now. If you wait 10 years, the tree is bigger and worth more, but the land is tied up. So when do you cut?
His formula priced every future planting and harvesting cycle. The result is called the land expectation value. Foresters still use it today. The formula stayed in forestry textbooks for over 150 years. In 2013, Mark Spitznagel applied it to stocks in The Dao of Capital.
How Spitznagel applied it to stocks
His point: a company is doing the same thing as a managed plantation.
The yearly profits are the harvest. The company can pay them out as dividends, or it can keep them and put them back into the business.
If the business reinvests at a high rate of return, those held-back profits compound. A dollar held back at 20% return per year becomes about 6 dollars in 10 years. The same dollar paid out as a dividend stays a dollar.
The Faustmann Ratio asks two questions.
1. What is the long stream of reinvested earnings worth? and
2. How does that compare to what the market is asking you to pay today?
See which companies pass all four Faustmann filters
Run the screen across 22,000+ companies in 30+ countries. Usually leaves 30 to 60 names worldwide — a manageable list to research in an evening.
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How to calculate a practical version
The original formula uses discounting and infinite series. You do not need that to use the idea.
To use it you must focus on three numbers.
1. Return on Invested Capital (ROIC)
ROIC (Return on Invested Capital) measures how well a company turns invested capital into operating profit. An ROIC of 20% means every dollar reinvested produces 20 cents of operating profit per year. Higher is better.
I have written more about why ROIC matters here: Why ROIC Beats ROA for stock investing success.
2. Reinvestment rate
This is the share of profits the company keeps in the business, instead of paying out as dividends or buying back shares.
A young software company might reinvest 90% of profits. A mature utility might reinvest 30%.
A high ROIC only matters if the company reinvests. A 25% ROIC business that pays out everything cannot compound.
3. Current valuation
What does the market charge you for all this future compounding?
Look at the price-to-earnings ratio (P/E ratio) and the earnings yield (1 divided by P/E, written as a percent). A P/E of 12 means an earnings yield of 8.3%. That is what you earn on the company's profits at today's price.
What "Faustmann cheap" stock looks like
A stock is Faustmann cheap when the market price ignores the long compounding power of the business.
Here is the starting set of numbers you can use:
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ROIC above 15%
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P/E ratio below 15 (earnings yield above 7%)
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Five-year sales growth above 0%
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Debt-to-equity below 1.0
If a company hits all four, you have the Faustmann ratio idea on your side. You are paying a normal price for above-normal compounding.
The wider the gap between strong reinvestment numbers and a low valuation, the more attractive the stock.
Where this works best
The Faustmann Ratio works best in asset-heavy, cyclical businesses. Industrials, materials, energy, speciality chemicals, niche industrial equipment. These businesses have long asset lives and a clear link between capital invested and future profits. The math fits.
Real estate investment trusts (REITs), utilities, and infrastructure companies also fit well. They reinvest steadily over decades.
Where this does not work
Asset-light technology businesses are harder to value this way. Their value comes from software code, brands, and network effects, not from physical capital that recycles. ROIC numbers can be misleading because the real assets are not on the balance sheet.
Banks and insurance companies are also a poor fit. Their balance sheets work differently, and ROIC means something different on a financial balance sheet.
Mature cash cows that pay out almost everything as dividends have very little reinvestment. There is nothing to compound. A simple high dividend yield analysis works better for those.
I use the Faustmann logic where it fits, and other tools where it does not.
How to find these companies in the Quant Investing screener
The screener has every input you need. Here is a screen you can run every month to find Faustmann style compounders:
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ROIC: top 20% of companies
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Earnings Yield: top 30%
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5-year sales growth: above 0%
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Debt-to-equity: below 1.0
Then sort the results by Magic Formula rank, Qi Value or the Quant Value Composite score. This usually leaves 30 to 60 companies worldwide. A manageable list to research.
You can read more about the Magic Formula and how it uses ROIC and earnings yield here: Magic Formula back test (2022 update).
Honest expectations
Not every Faustmann pick will work. Some companies will hit a bad cycle. Some will lose their competitive edge. Some will be value traps, where the cheap price reflects a real problem you missed.
This is normal for any value strategy. The point is follow the strategy over the long term so you have the principle on your side over time, not on every single position.
That is why I always recommend that you do three things:
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Hold 20 to 30 companies, not 3
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Use a strict 20% trailing stop loss on every position, no questions asked
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Stop buying when the broader market is falling - in other words when a market is below its 200 day simple moving average.
You can read more about why drawdowns are normal and how to handle them here: Stock Drawdowns Are Normal Be Prepared.
Three things to do this week
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Open the screener and enter the four filters above.
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Pick five names from the list and read the latest annual report.
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Drop any company with declining ROIC, a sudden jump in debt, or shrinking sales.
That is the Faustmann process in practice. Patient and disciplined.
Find your own Faustmann compounders this month
The Quant Investing screener has all four filters built in: ROIC, earnings yield, 5-year sales growth, and debt-to-equity. Save the screen once and re-run it every month across 22,000+ companies in 30+ countries.
No credit card needed. Cancels automatically after 30 days. Or see what is included with the full screener.
Frequently asked questions about the Faustmann Ratio
1. What is the Faustmann Ratio?
The Faustmann Ratio is a valuation method that compares the price of a company to the long-term value of its reinvested earnings. It came from forestry in 1849 and was applied to stocks by Mark Spitznagel in his 2013 book The Dao of Capital.
2. Who invented the Faustmann Ratio?
Martin Faustmann, a German forester, published the original formula in 1849 to value timber plantations. Mark Spitznagel adapted it for stock investing in 2013.
3. How do you calculate the Faustmann Ratio for a stock?
A practical version uses three inputs. Return on Invested Capital (ROIC), the reinvestment rate (the share of profits the company keeps), and the current valuation (P/E ratio or earnings yield). A stock is Faustmann cheap when ROIC is above 15%, the company reinvests most of its profits, and the P/E is below 15.
4 What ROIC level signals a long-term compounder?
ROIC sustained above 15% over several years. This shows the company has a real edge in turning capital into profit, which is what drives long-term compounding.
5. What types of companies does the Faustmann Ratio work best for?
Asset-heavy, cyclical businesses. Industrials, materials, energy, specialty chemicals, niche industrial equipment, REITs, utilities, and infrastructure companies. These have long asset lives and a clear link between reinvested capital and future profits.
6. Where does the Faustmann Ratio not work?
It does not work well for asset-light technology companies, banks and insurance companies, or mature cash cows that pay out most of their profits as dividends. For those, other valuation tools fit better.
7. How can I find Faustmann Ratio stocks in the Quant Investing screener?
Set four filters in the Quant Investing screener. ROIC in the top 20%, Earnings Yield in the top 30%, 5-year sales growth above 0%, and Debt-to-Equity below 1.0. Then sort by Magic Formula rank or Quality Score.
8. Is the Faustmann Ratio the same as the Magic Formula?
No. The Magic Formula combines earnings yield and ROIC into a single ranking. The Faustmann Ratio is broader. It also looks at the reinvestment rate and the durability of returns, which is what compounds value over decades.
9. Does the Faustmann Ratio require holding stocks for years?
Yes. The whole point is to capture compounding from reinvested earnings, which takes years to play out. I still apply a 20% trailing stop loss on every position to limit losses on picks that go wrong, but the intent is multi-year holding.
10. Where can I read the original source on the Faustmann Ratio?
Mark Spitznagel's 2013 book The Dao of Capital is the source for the stock investing adaptation. The original 1849 forestry formula by Martin Faustmann is in academic forestry and natural resource economics literature.
11. Can I get Faustmann-style stock picks without doing the screening myself?
Yes. The Quant Value newsletter uses a multi-factor strategy that includes ROIC, valuation, and quality screens, and gives you a ready buy and sell list each month.
Your value analyst
Tim
PS Try the screener free for 30 days here. It takes about 4 minutes to set up your first screen.
PPS It is so easy to put things off and forget, why not start the free demo right now?
