Magic Formula to create wealth in the stock market
The magic formula is an investment technique that relies on a mathematical calculation to find stocks that are undervalued and overvalued. The underlying principle of the Magic Formula is to buy stocks with a high earnings yield (cheap) and sell stocks with low earnings yields (expensive).
The Magic Formula Investing strategy is an alternative to the traditional buy and hold approach to investing. It can be used in many different types of markets and it was created by Joel Greenblatt, a hedge fund manager who has been working in the investment business for over 40 years. Greenblatt described his magic formula investing in his book ‘The Little Book That Beats The Market’. He has claimed that this formula has helped him generate over 24% annual returns between 1988 and 2009 while keeping his risk at a minimum.
Most investors are not able to find high-quality stocks. This is where Magic Formula Investing comes in. It is a system that scours for stocks with the highest earnings yield and highest Return on Capital ratio.
The Magic Formula is a way to weed out many of the bad stocks and leave you with only those with the most potential for healthy growth and high quality.
The magic formula invests in companies that have a high earnings yield, and a high return on capital, ratio. The formula for calculating the 2 factors is as shown below –
Earnings Yield : Earnings Before Interest and Tax (EBIT) / Enterprise Value = Earnings Yield
Return on Capital : EBIT / (Net Fixed Assets + Working Capital) = Return on Capital
Both the ratios should be expressed as percentages and investors should look for companies with high Earnings Yield and High Return on Capital. Investors should avoid stocks with low liquidity and stocks from Banking and Financial services while applying this formula.
Greenblatt recommended that investors should use this strategy for a minimum of 5 years since the magic formula generally selects good companies and they might not be available cheap. But over a period of 5 years it pays off to buy good quality companies at good prices.
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