The magic formula investing is a strategy created by hedge fund manager and Columbia University professor Joel Greenblatt: buying good companies at a good price.
How to Calculate Investment Ratios in the Magic Formula?
There are two ratios in the magic formula. The first is the earnings yield: EBIT/EV. This is earnings before interest and taxes divided by enterprise value:
The simplest and most common ratio for this is earnings/price. Greenblatt prefers EBIT to earnings, as EBIT provides a more accurate comparison among companies with different tax rates. He favors enterprise value over price because enterprise value also considers the company’s debt. Therefore, EBIT/EV gives a better picture of overall profitability than earnings/price.
The second ratio is return on capital, which is EBIT/(net fixed assets + working capital):
The first ratio looks at earnings before interest and taxes relative to enterprise value. The second ratio focuses on profits related to tangible assets. Many assets listed on the balance sheet wear out over time as their utility is consumed. These assets are called “fixed assets.”
Net fixed assets are the fixed assets minus accumulated depreciation and any liabilities related to the assets. This gives a more accurate picture of the true value of the company’s assets compared to simply looking at total assets on the balance sheet. Working capital is also part of this ratio and represents current assets minus current liabilities. This gives an idea of whether the company is capable of sustaining operations in the short term.
Although the two ratios in the magic formula seem small, they actually calculate a lot of data about the internal workings of the company, including:
- Profits
- Interest
- Tax rates
- Stock price
- Debt
- Asset depreciation
- Current assets
- Current liabilities
How Does Magic Formula Investing Work?
The magic formula investment strategy has nine rules to follow:
- Include only stocks with a market capitalization greater than $50 million, $100 million, or $200 million. Exclude financial stocks and utilities. Exclude foreign companies or American Depositary Receipts (ADRs).
- Determine the earnings yield of the company, which is EBIT / EV.
- Determine the return on capital of the company, which is EBIT / (net fixed assets + working capital).
- Based on steps 1 to 3, rank the results according to the earnings yield and return on capital. Rank as percentages.
- Invest in 20 to 30 of the top-ranked companies, accumulating two to three positions per month over a 12-month period.
- Rebalance the portfolio once a year, selling losers after 51 weeks of purchase, and selling winners after 53 weeks of purchase. This is for tax purposes, as losers are held for less than a year and winners for more than a year.
- Use the strategy only for the long term. For example, choose to implement it for at least five years.
Limitations of Magic Formula Investing
You may see significant variance in returns from another investor, even if you are both following the same strategy. When buying stocks, the stocks you purchase will play a role in determining your returns. For example, the initial calculations of the formula may yield different results on different days, as some stocks may move in or out of the top 30 to 50 stocks that meet the criteria.
This variance is another reason Greenblatt recommends using the strategy for more than five years. Due to short-term market fluctuations, you will see better long-term returns from buying good companies at good prices.
Source: https://www.thebalancemoney.com/what-is-magic-formula-investing-4150688
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