This stock definitely proves itself to score very high on Greenblatt’s magic formula for this year. $CSCO Return on Capital = 0.508, or 50.8%Īgain, this is a very high value for a magic formula metric. Remember that Return on Capital = EBIT /. Now it’s time to bring this all back to the Return on Capital formula. The simple version of Working Capital can be thought of as Current Assets – Current Liabilities. Net fixed assets, as defined by Joel Greenblatt, is Total Assets – Total current assets – Total Intangibles & goodwill. Since we already have the EBIT figure from before, we just need to find the net fixed assets and working capital. Now it’s time to do the Return on Capital formula. Compare this to Cisco’s current P/E of 15.18, and you can see that it seems like Cisco’s true earnings power could be undervalued by the market. An Earnings Yield from that definition at 7.87% would be the same as a stock with a P/E of 1/0.0787 = 12.7.įor those who aren’t familiar with whether 7.87% is a good figure for earnings yield or not, this gives you the P/E version equivalent of 12.7. One other way to calculate the earnings yield (one that Joel Greenblatt doesn’t advocate) would be to take the inverse of the Price to Earnings ratio (or E/P). Taking the EBIT value above, we get an earnings yield of the following:
The last part is Market Capitalization, which we can quickly lookup using a website like Google Finance. Here are some key financials we can examine from the company’s latest 10-K filing. In this case, we’ll start with the highest ranking stocks with a minimum market capitalization of $10B. Let’s look at the financials for a company in the list of high ranking magic formula stocks from Greenblatt’s website. Sell all positions after a one year holding period (selling losers before 365 days to utilize short term tax harvesting, selling winners after 365 days to get long term capital gains instead of short term).Buy 2-3 of the highest scoring stocks each month, for 12 months.Avoid stocks from the utility and finance industry.In addition to looking for stocks with a high earnings yield and return on capital, Greenblatt included the following criteria: More specifically, Greenblatt combined a high earnings yield with a high return on capital to pick only the stocks with seemingly the best chances for future success. He replicated similar results in numerous backtests. Picking only the best stocks that scored well in both areas, Greenblatt was able to produce outstanding returns for his investors. The basic premise of the magic formula is to combine a highly profitable and efficient company (and one that can quickly and easily grow) with a low valuation metric based on earnings. He wrote about this track record in his book, You Can Be a Stock Market Genius. Joel Greenblatt ran the hedge fund Gotham Capital from 1985 – 1995 for an annualized return of 50%. Return on Capital = EBIT / (net fixed assets + working capital) Introduction to Joel Greenblatt and “The Magic Formula” The way Greenblatt defined earnings yield and return on capital (which are somewhat subjective measures) was as follows: That formula consisted of two distinct parts: earnings yield and return on capital. In the book, Gleenblatt taught about a magic formula. Investors looking to chase higher market returns can look to Joel Greenblatt’s book The Little Book That Beats the Market.
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