The Magic Formula is a value investing strategy invented by the hedge fund manager Joel Greenblatt in the bestselling and highly recommended Little Book that Beats the Market. It focuses on finding quality value stocks using a blended ranking system (the Magic Formula rank) composed from two fundamental ratios: Return on Capital (which Greenblatt argues is the best determinant of whether a business is a good one) and Earnings Yield (his favoured measure for cheapness). He summarised his philosophy with the maxim "buying cheap stocks at bargain prices is the secret to making lots of money". In the fourth edition of his book Greenblatt claimed the top scoring portfolio of 30 stocks appreciated by 30.8% each year over the previous 17 years, though he stressed that the strategy could underperform during periods of up to two years. Having now sold hundreds of thousands of copies, the "Magic Formula" is credited for reinvigorating the practice of value investing. more »
The Market Cap is a measure of a company's size - or specifically its total equity valuation. It is calculated by multiplying the current Share Price by the current number of Shares Outstanding. It is stated in Pounds Sterling.
Stockopedia explains Mkt Cap £m...
Market Capitalisation only takes into account the value of the company's shares (equity), it ignores the amount of debt a company may have taken on and therefore isn't the best indicator of the company's size. The Enterprise Value adds the net debt to the Market Cap and is a better indicator of the minimum amount that an acquiring company may have to pay to buy the firm outright.
This is Stockopedia's version of the Magic Formula as defined in Joel Greenblatt's bestselling book "The Little Book that Beats the Market". You can learn more about the Magic Formula in this article and also in our Magic Formula FAQ.
Stockopedia explains Magic Formula Rank...
Joel Greenblatt's Little Book that Beat the Market became a financial publishing phenomenon. In a simple writing style, the successful hedge fund investor showed how picking 'good' stocks at 'cheap' prices was enormously profitable. He claims that a portfolio of the top 30 Magic Formula stocks has averaged a 17-year annual return of 30.8% and beats the S&P 500 96% of the time. It should be noted that these returns are volatile and require a fully diversified portfolio. Greenblatt suggests sticking to A+ stocks (in the top 10%) for the best chance of outperformance and ideally to a basket of the top 50 ranked stocks in the market.
As defined in the Little Book that Beats the Market, the earnings yield compares the profit generated with the market's valuation of the company. It is defined as operating profit divided by enterprise value.
Many refer to it as the EBIT/EV (Earnings before interest and tax / Enterprise Value)/
Enterprise value is used by Greenblatt rather than market capitaliation to reflect the competing claims of debt and equity holders on the business. This penalizes companies that carry a lot of debt and little cash, and rewards firms with a lot of cash - a useful distinction not reflected in the P/E ratio.
Operating earnings are used instead of net income to eliminate the distortions caused by recognized tax benefits or goodwill write-downs that have very little to do with the company's profitability.
Stockopedia explains Earnings Yield %...
In the case of negative Entreprise Value stocks, we replace the Enterprise Value with a 1 to avoid having a negative denominator (the alternative would be to print n/a but these stocks are obviously good from an Earnings Yield perspective).
Return on Capital is used by Joel Greenblatt in his Magic Formula to measure the rate of return a business is making on the total capital used in the business. His definition uses EBIT / (Net Working Capital + Net Fixed assets).
Stockopedia explains ROC % Greenblatt...
Companies that can earn a high ROC over time generally have a special advantage that keeps competition from destroying it.