The Little Book That Beats the Market – Magic Formula

Lessons/Primers
  1. Most people have no business investing in individual stocks on their own!
  2. Reread summary point number 1
  3. But if you must… and you can actually predict normalized earnings several years down the road, use those estimates to figure out earnings yield and return on capital. Then, use the principles of the magic formula to look for good companies at bargain prices based on your estimates of normal earnings
  4. If you truly understand the business that you own and have a high degree of confidence in your normalized earnings estimates, owning five to eight bargain-priced stocks in different industries can be a safe and effective investment strategy
  5. Most people have no business investing in individual stocks on their own! (Did I already mention that?)

The Magic Formula

  1. Return on Capital
    1. EBIT / (Net Working Capital + Net Fixed Assets)
    2. Return on capital measured by calculating the ratio of pre-tax operating earnings (EBIT) to tangible capital employed (Net Working Capital + Net Fixed Assets). This ratio used rather than the more commonly used ratios of ROE or ROA for several reasons
    3. EBIT used in place of reported earnings because companies operate with different levels of debt and differing tax rates
    4. Net working capital + Net fixed assets used in place of total assets or equity. The idea here is to figure out how much capital is actually needed to conduct the company’s business
  2. Earnings Yield
    1. EBIT / Enterprise Value
    2. This ratio was used instead of the price to equity because enterprise value takes into account both the price paid for an equity stake in the business as well as the debt financing used by a company to help generate operating earnings
    3. By using EBIT and comparing it to enterprise value, we can calculate the pre-tax earnings yield to the full purchase price of the business
    4. Allows us to put companies with different levels of debt and different tax rates on an equal footing when comparing earnings yield

“Simply perfect. One of the most important investment books of the last 50 years!” – Michael Price

The Little Book That Beats the Market, Joel Greenblatt

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