Greenblatt’s Magic Formula
Long-term success relies on both a sound strategy and the discipline to follow your approach during bull and bear markets. In “The Little Book That Still Beats the Market” (John Wiley & Sons, 2010), Joel Greenblatt shows that his “Magic Formula” approach holds up over the long term, but that you need to be prepared for brief runs when it underperforms the market. The approach seeks out good companies with a high return on invested capital that can be purchased at an attractive pretax earnings yield.
Greenblatt measures the strength of a business by examining its return on capital, which he defines as operating profit (EBIT, earnings before interest and taxes) divided by tangible investment capital (net working capital plus net fixed assets). If you do not have access to this variable, Greenblatt suggests that investors use return on assets (net income divided by assets) or visit his website (www.magicformulainvesting.com), which has a free magic formula screening tool.
To help value a business, Greenblatt takes the price-earnings ratio, inverts it and tweaks the variables slightly. Greenblatt calculates earnings yield by dividing EBIT by the enterprise value. The enterprise value tries to reflect the minimum value to purchase a company outright. It is calculated by adding market capitalization, preferred stock, and total debt and subtracting excess cash. Greenblatt notes that you can also look for low price-earnings ratios, but warns to avoid firms with extremely low ratios because earnings may be unusual in some way.
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