AAII, the American Association of Individual Investors

Greenblatt’s Magic Formula

by John Bajkowski

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.

Stocks that made this issue’s First Cut are domestic, exchange-listed stocks with a minimum price of $5.00 per share and a market cap of at least $50 million. Greenblatt also excludes financials and utilities because of their unique financial structures. To calculate the magic formula, the rank value of return on capital was combined with the rank value of the return on enterprise value. The 30 stocks with the lowest magic formula total passed the First Cut. Greenblatt suggests building a 20- to 30-stock portfolio by selecting five to seven stocks every two to three months.

—John Bajkowski, President of AAII

Magic Formula Screen Criteria for Use With AAII’s Stock Investor Pro

Data Category Field Operator Factor Compare To
Company Information
Exchange 
Not Equal
Over the Counter
Company Information
ADR/ADS Stock
Is False
Company Information
Sector
Not Equal
Utilities
Company Information
Sector
Not Equal
Financial
Company Information
Country
Equals
United States
Price and Share Statistics
Market Cap
>=
50
Magic Return on Capital*
>
25
Magic EBIT to Enterprise Value*
>
value changes until exactly 30 companies pass
 
*Custom Field. See below for information on creating custom fields.
 

Custom Fields for Use With AAII’s Stock Investor Pro

Custom Field Name Formula
Enterprise Value
[Market Cap Q1] + [Long-term debt Q1] + [Preferred stock Q1] + [Short-term debt Q1] - [Cash Q1]
Magic EBIT
[Pre-tax income 12m] + IIF(IsFieldNull ( [Interest expense 12m] ) =0,0, [Interest expense 12m] )
Magic EBIT to Enterprise Value
(IIF( [Magic EBIT]>0, [Magic EBIT], null) / IIF( [Enterprise Value]>0, [Enterprise Value], null))*100
Magic Tangible Capital
[Accounts receivable Q1] + [Inventory Q1] + [Cash Q1] - [Accounts payable Q1]
Magic Return on Capital
(IIF( [Magic EBIT]>0, [Magic EBIT], null) / IIF( [Magic Tangible Capital]>0, [Magic Tangible Capital], null))*100
 
Stock Investor Pro subscribers: Click here to download a .txt file with the custom fields for copying and pasting into the Custom Field Editor.