Magic Formula Equation:

Finds above –average companies that we can buy a below-average prices

Buying good companies that generate

1. High Return on Capital = EBIT/ (Net Working Capital + Net Fixed Assets)

EBIT - allows the investor to view and compare the operating earnings of different
companies without the distortions from differences in tax rates and debt levels. With
EBIT we can compare actual earnings from operations to the cost of the assets used to
produce those earnings

Net Fixed Assets - Determines how much capital is actually needed to conduct the
company’s business. (Also called tangible capital employed)

Net Working Capital – Company has to fund its receivables and inventory (excess cash
not needed to conduct the business was excluded from this calculations) but does not
have to give out money for its payables, as these are effectively an interest-free loan. In
addition a company must also fund the purchase of fixed assets necessary to conduct its
business

2. High Earnings Yield = EBIT/Enterprise Value

How much a business earns relative to the purchase price of the business

Enterprise Value – market value of equity + net interest bearing debt

Summary:

1. Most people and businesses can’t find investments that will earn very high rates of return.
A company that can earn a high return on capital is therefore very special
2. Companies that earn a high return on capital may also have the opportunity to invest
some or all of their profits at a high rate of return. This opportunity is very valuable. It
can contribute to a high rate of earning growth
3. Companies that achieve a high return on capital are likely to have special advantage of
some kind. That special advantage keeps competitors from destroying the ability to earn
above-average profits.
4. Be eliminating companies that earn ordinary or poor returns on capital, the magic formula
starts with a group of companies that have a high return on capital. It then tries to buy
these above-average companies at below-average prices.
5. Since the magic formula makes overwhelming sense, we should be able to stick with it
during good times and bad.

In Short

Companies that achieve a high return on capital are likely to have a special advantage of some
kind. That special advantage keeps competitors from destroying the ability to earn above-average
profits.
 Magic Formula Investing.com Screener Steps:

1. Use screener on website

2. Market cap 50 million or over 200 million, or over 1 billion. Most individuals, companies
with market caps. Above 50 or 100 million should be ok
3. Follow the instructions to obtain a list of top-ranked magic formula companies
4. Buy 5 to 7 top ranked companies. To start, invest only 20 to 33 percent of the money you
intend to invest during the first year.
5. Repeat step 4 every 2 or 3 months until you have invested all of the money you have
chosen to allocate to your magic formula portfolio. After 9 or 10 months, this should
result in a portfolio of 20 to 30 stocks (7 stocks every 3 months, 5 or 6 stocks every 2
months)
6. Sell each stock after holding it for 1 year. For taxable accounts, sell winners after holding
them a few days more than one year and sell losers after holding them a few days less
than one year. Us the proceeds from any sale and any additional investment money to
replace the sold companies with an equal number of new magic formula selections as
(step 4)
7. Continue this process for many years. Remember you must be committed to continuing
this process for a min. of 3 to 5 years, regardless of results. Otherwise you will most
likely quit before the magic formula has a chance to work.

General Screening Instructions: Generic Screener

When not using Magic Formula Investing screener, a couple of items to consider

1. Use return on assets as screening criterion, ROA at 25%. This will take the place of
return on capital from the magic formula study.
2. From the resulting group of high ROA stocks, screen for those stocks with the lowest PE
ratios. This will take the place of earnings yield from the magic formula strategy.
3. Eliminate all uts and financial stocks, Mutual funds, banks and insurance companies from
the list
4. Eliminate all foreign companies
5. If a stock has a very low PE ratio say 5 or less, that may indicate that the previous year or
the data being used are unusual in some way. You may want to eliminate those stocks
from your list. You may also want to eliminate any company that has announced earnings
in the last week. This should help minimize the incidence of incorrect or untimely data.
6. After obtaining list, follow steps 4 and 8.

Annualized Return – (1988-2009) – The best-ranked stocks perform the best and as the
rankings drop so do the returns:

Group 1 15.2% Group 6 10.2

Group 2 12.7 Group 7 8.8
Group 3 12.1 Group 8 7.1
Group 4 11.5 Group 9 4.1
Group 5 10.7 Group 10 (0.2)
Important Notes:

The ROA used in step 1 often ignores the difference between reported equity, and tangible equity
and has distortions due to differing tax rates and debt levels

PE values are greatly influenced by changes in debt levels and tax rates, while EBIT/EV is not.
The magic formula appears to work very well over the long term.

The magic formula often doesn’t work for several years in a row

Most investors won’t or can’t stick with a strategy that hasn’t working for several years in a row.

The magic formula is a long-term strategy.

The magic formula tries to buy companies that provide the best combination of buying a stock
that is both cheap in price and a good company.