Magic Formula Stocks

by John Bajkowski

Magic Formula Stocks Splash image

Successful investment approaches can be simple or complex. In “The Little Book That Beats the Market” (John Wiley & Sons, Inc., 2006, www.magicformula
), Joel Greenblatt presents the “Magic Formula” investment approach that relies on two simple rules: seek out good companies with a high return on invested capital that can be purchased at a low price that provides a high 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). Stocks passing the First Cut have a return on invested capital of 25% or higher. If you do not have access to this variable, Greenblatt suggests that investors use return on assets (net income divided by assets).

To help value a business, Greenblatt takes the price-earnings ratio, inverts it and tweaks the variables slightly. Greenblatt calculates earnings yield by dividing operating earnings 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. Stocks passing the First Cut have a minimum EBIT to enterprise value earnings yield of 25%. As a substitute, Greenblatt notes that you can look for low price-earnings ratios, but warns of avoiding firms with extremely low ratios because earnings may be unusual in some way.

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John Bajkowski is president of AAII.


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