The Magic Formula, also known as the Magic Formula in English, is an investment strategy proposed by Joel Greenblatt. In this investment strategy, Joel Greenblatt uses ROC (return on capital) and Earnings Yield (yield) to analyze and rank different listed companies, and then screens investment objects based on their principles of "buying at a cheap price" and "buying a good company", and selects the top 20 to 30 companies for investment. Through this set of magic formula investment strategies, Joel GreenBlatt achieved an annual return of 30% from 1985 to 2005. Joel Greenblatt is a famous American economics scholar, investor, author, hedge fund manager, financial professional and value investment expert. He graduated from the Wharton School of the University of Pennsylvania and later became an adjunct professor at Columbia University Business School. Joel Greenblatt founded Gotham Asset Management and served as its fund manager to help investors with various investment guidance. His fund Gotham Capital achieved an astonishing annual return of 40% from 1985 to 1995. In 2005, Joel Greenblatt published his book "The Little Book That Beat the Market", in which he first proposed the "Magic Formula Investing" strategy concept. @Amazon Affiliate Link The main idea is: companies with high ROC, high Earnings Yield, and low market capitalization are good investment targets. By choosing cheap stocks among the top 20 to 30 companies calculated by ROC calculation and Earnings Yield calculation, you can obtain returns higher than the average market return in future long-term investments. The main advantage of the Magic Formula Investing strategy is that it is simple to use. It only requires simple calculations and sorting, and strictly follows the rules to get a clear ranking of companies, which reduces the impact of personal emotions and irrational factors on the evaluation during the screening process. Therefore, in theory, all investors can use the Magic Formula Investing strategy to screen investment objects. Two important indicators in Amazing Company When using Magic Company to rank listed companies, two important indicators are needed: Earning Yield Return on Capital (ROC) How to calculate the rate of return? Yield, also known as Earning Yield in English, is used to evaluate the return on investment of a company's stocks, that is, the proportion of profit that can be obtained by purchasing the company's stocks at the current price. Yield is calculated by dividing a company's earnings before interest and tax (EBIT) by its enterprise value (EV), as follows: Earning Yield = EBIT/EV Among them, EBIT is earnings before interest and taxes and can be found on the income statement of a financial statement. EV is enterprise value, which is equal to the company's market capitalization plus the fair value of the company's debt, minority interests, and preferred stock, minus cash and cash equivalents. A high yield means investors are receiving more operating profit per unit invested, which is often seen as a sign of a lower stock valuation and a more attractive investment. Greenblatt's magic formula selects stocks based on high earnings yield (i.e., low valuation) and high return on capital (i.e., high efficiency). How to calculate ROC?
ROC, the full English name is Return on Capital, which is "return on capital". It is an indicator that measures the efficiency of listed companies in converting invested capital into profits, which is different from the calculation method of ROIC (Return on Invested Capital). In general, the higher the ROC value, the higher the company's ability to convert its capital into profits, which means the company is more worthy of investment. Joel Greenblatt will focus on the top-ranked companies as investment objects. ROC calculates the ratio of profit to tangible capital investment, and profit uses earnings before interest and taxes, that is, Earnings Before Interest and Taxes (EBIT); Tangible capital investment refers to the capital investment actually used in production and operations, that is, the sum of net working capital (Net Working Capital) and net fixed assets (Net Fixed Assets). ROC is calculated by dividing the company's earnings before interest and taxes (EBIT) by the company's tangible capital investment (Tangible Capital Employed), that is: Return on capital = EBIT / tangible capital invested capital ROC = EBIT / Tangible Capital Employed Profit before interest and taxes refers to the profit before taxes and interest are deducted, that is, net income plus interest and taxes, that is: EBIT = net income + interest expense + tax expense Net income and taxes can be found on a company's Statement of Operations; interest can be found on the Statement of Cash Flows. The calculation method of tangible capital investment is as follows: Tangible capital investment = net working capital + tangible fixed assets Tangible Capital Employed = Net Working Capital + Net Fixed Assets Tangible fixed assets mainly refer to fixed assets such as real estate, factories and production equipment that are actually used for production. Net working capital refers to the difference between a company's current assets and current liabilities, which is: Net working capital = current assets – current liabilities Net Working Capital = Current Assets – Current Liabilities These two values can be found on a company's balance sheet (Balance Sheets). How to calculate Apple's ROC? This chapter will perform example calculations by using Apple's 10-K financial report released in September 2021: The income statement, balance sheet and cash flow statement in AAPL's financial report are as follows: Income Statement (Statements of Operations): Balance Sheets: Other Income/ (Expense), Net Among them: net income Net Income $94,680M interest Interest $2,645M taxes Provision for Income Taxes $14,527M current assets Total Current Assets $134,836M current liabilities Total Current Liabilities $125,481M fixed assets Total Non-Current Assets $216,166M Property, Plant, and Equipment Property, Plant, and Equipment $39,440M So: EBIT = Net Income + Interest + Taxes
= $94,680M + $2,645M + $14,527M = $111,852M Net working capital = current assets – current liabilities; = $134,836M – $125,481M = $9,355M Capital = Net Working Capital + Property, Plant, and Equipment = $9,355M + $39,440M = $48,795M So, ROC = EBIT – Capital = $111,852 M / $48,795 M = 229% write at the end Joel Greenblatt's magic formula will rank companies based on ROC and Earning Yield, and then add the two rankings to rank the top 20 to 30 companies in order of high and low. Note that the magic formula does not apply to Finance and Utility companies either. In addition, the evaluation results in short-term investments have large deviations, and generally better returns can be obtained in long-term investments of three to five years. More value investing What are minority interests? How to handle the profits of subsidiaries? What is Shareholders’ Equity? Shareholders’ Equity What is the Price to Cash Ratio (P/CF)? How to calculate? What is Operating Expense OpEx? Operating Expenses What is Cost of Goods Sold (COGS)? How to calculate? What is company profit? Gross profit, operating profit, net profit What is enterprise value multiple? Enterprise Multiple What are preferred shares? Preferred Stock What is operating leverage? Degree of Operating Leverage What is debt service ratio? Debt Service Coverage Ratio