John Greenblatt’s Magic Formula: Unleashing the Power of Value Investing
Introduction:
John Greenblatt’s Magic Formula is an investment strategy that combines the principles of value investing with quantitative analysis. Developed by Joel Greenblatt, an accomplished investor and author, the Magic Formula aims to identify undervalued stocks with strong earning potential.
In this article, we will explore the Magic Formula in detail and provide multiple examples to illustrate its application.
Understanding John Greenblatt’s Magic Formula:
The Magic Formula focuses on two key factors: earnings yield and return on invested capital (ROIC). By combining these metrics, the formula aims to identify companies that offer a combination of high earnings relative to their price and strong returns on capital.
1. Earnings Yield:
Earnings yield is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its enterprise value (EV). The higher the earnings yield, the more attractively priced the stock may be. This metric helps identify companies with potentially higher returns.
2. Return on Invested Capital (ROIC):
ROIC measures a company’s ability to generate profits from the capital invested in its operations. It is calculated by dividing a company’s operating income by its total invested capital (debt and equity). A higher ROIC indicates efficient and profitable use of capital.
The Magic Formula combines these two factors by ranking companies based on their earnings yield and ROIC. The highest-ranked stocks are considered potential investment opportunities.
Example 1:
Let’s consider two companies, Company A and Company B. Company A has an earnings yield of 8% and an ROIC of 15%, while Company B has an earnings yield of 6% and an ROIC of 20%.
Using the Magic Formula, we rank the companies based on their combined scores:
Company A: Earnings Yield (8%) + ROIC (15%) = 23
Company B: Earnings Yield (6%) + ROIC (20%) = 26
According to the Magic Formula, Company B has a higher score and may be considered a more attractive investment opportunity.
Example 2:
Now, let’s consider two different companies, Company X and Company Y. Company X has an earnings yield of 10% and an ROIC of 12%, while Company Y has an earnings yield of 7% and an ROIC of 18%.
Using the Magic Formula, we calculate their combined scores:
Company X: Earnings Yield (10%) + ROIC (12%) = 22
Company Y: Earnings Yield (7%) + ROIC (18%) = 25
In this example, Company Y has a higher score, indicating a potentially more attractive investment option according to the Magic Formula.
Conclusion:
John Greenblatt’s Magic Formula is a popular investment strategy that combines the concepts of value investing and quantitative analysis. By considering a company’s earnings yield and return on invested capital, the formula aims to identify undervalued stocks with strong earning potential.
However, it is important to note that the Magic Formula is just one tool among many and should be used alongside thorough research and analysis. It is recommended to consult with a financial advisor or professional before making any investment decisions based on the Magic Formula or any other investment strategy.