The Magic Formula was created by Joel Greenblatt and first described in his best-selling book The Little Book That Beats the Market. Greenblatt claimed that this formula achieved an annual return of 23.7 percent over a 17-year period from 1988 to 2004. The overall market achieved a return of 12.3 percent over the same period. Various independent backtesting studies confirmed that the formula beats the market in the US and internationally, though not necessarily by the same margin as presented by Greenblatt.
The Magic Formula uses the principles of value investing and combines the investment philosophies of Benjamin Graham and Warren Buffet. Essentially, this strategy seeks to buy good companies at bargain prices.
The obvious question you may have is how can the Magic Formula keep working when everyone knows about it? Greenblatt claimed that the formula works well in the long-term, but in the short-term Mr. Market may price stocks based on emotion, thus the formula can underperform the market for several years in a row. Most investors just cannot stick with the strategy long enough for it to work. This creates a great opportunity for investors with a long-term investment horizon. Therefore, this strategy is most suitable for investors with patience and a long-term view.
How the Formula Works
The original Magic Formula uses the Earnings Yield as the cheapness factor and Return on Invested Capital as the quality factor. The Earnings Yield is calculated as EBIT / Enterprise Value, where EBIT represents earnings before interest and taxes, and where Enterprise Value is calculated as market cap + debt – cash. Return on Invested Capital (ROIC) is calculated as EBIT/(Net Tangible Assets + Net Working Capital).
- Cheapness Rank: Earnings Yield = EBIT/Enterprise Value
- Quality Rank: Return on Invested Capital = EBIT/(Net Tangible Assets + Net Working Capital)
Stocks are ranked based on these two metrics (where 1 is the highest rank), and then both ranks are added together (the best company has the lowest rank). The formula doesn’t look for companies that are the best in either of the metrics alone, but that are the best in combination.
To avoid putting too much weight on only one year of earnings, we use the latest available 3-year average pretax earnings and return on tangible assets. The idea behind using average earnings comes from Graham and Dodd’s classic text Security Analysis, where they argued for smoothing a firm’s earnings. They noted that one-year earnings are too volatile to offer a good idea of a firm’s true earnings power.
Magic Formula for Banks
Joel Greenblatt’s original formula excluded financial companies. With some imagination, we used the principles of the original Magic Formula and created a Magic Formula Screener for Banks. The “cheapness” factor is represented by the earnings yield (EY) and measured by calculating the ratio of pretax earnings (EBT) to market capitalization. The “quality” factor is represented by the return on tangible common equity (ROTCE) and measured by the ratio of pretax earnings (EBT) to tangible common equity (TCE), where tangible equity is calculated as total equity – goodwill – intangible assets – preferred stock.
- Cheapness Rank: Earnings Yield = EBT/Market Cap
- Quality Rank: Return on Equity = EBT/Tangible Equity
As before, we use 3-year average pretax earnings and return on tangible equity. Smoothing earnings and ROE provides a better measure of a firm’s profitability and earnings power.