A Magic Formula For A New Year

As we stare down the end of 2020 and welcome 2021, you may be looking for some magic formula to use in your investing. If you are, you are in luck, at least in name only and possibly more. This is a simple fundamental formula for investing developed by Joel Greenblatt in his 2006 book, “The Little Book That Beats the Market.”

The historical returns for this approach have proven fruitful, but like all systems, a lot comes down to application. Having learned this approach several years ago, this system incorporates two important facets of fundamental stock evaluation: valuation and profitability. If you are someone that incorporates equity investments in your portfolio, these are two evergreen points of analysis.

Magic Formula Metrics

Many fundamental systems incorporate a litany of criteria that is quite limiting, but not the Magic Formula. The great thing about simple is that it provides a lot of latitude for top-down oriented analysis. This may not have been the intent, but it is an outcome. Let’s take a look at the two fundamental criteria:

  1. Earnings Yield
  2. Return on Capital

Earnings Yield

If you’re familiar with earnings yield, you’ll need to relearn what it is for this formula. Rather than taking the inverse of P/E, this calculation replaces EPS with EBIT and market capitalization with enterprise value (EV).

This is a rather clever approach in that it takes away some of the effects of capital structure for a business and the takeover value of the company. I’ve been a fan of EV/EBITDA as a valuation measure for a long time, and so learning about this approach to earnings yield made a lot of sense to me.

By taking the inverse of a valuation metric like EV/EBIT, you now gain perspective of the return on the business while maintaining a valuation perspective. Also, there isn’t a minimum value for this metric, it’s all relative. That makes it great for letting the cream rise to the top.

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