Reviewed by Oct 05, 2020| Updated on
Magic formula investing is an investment strategy modelled by Joel Greenblatt. He is an American academic, investor, hedge fund manager, and writer. The formula was described in his book, "The Little Book That Beats the Market".
This formula is based on certain rules and methodologies that provide a simple yet disciplined approach to investing in companies which fit the specified criteria.
He suggests investing in cheap stocks, which have a high return on capital, as well as a high earnings yield. The goal is to surpass the average market return. The book claims that it does beat the S&P 500 index, 96% of the time.
The magic formula works as follows:
Market capitalisation refers to the share price multiplied by the number of outstanding shares. The minimum market capitalisation varies from investor to investor, and need not be set at $50 million, but could be set higher, at $100 million or even $200 million. It is all about personal choice.
The two ratios in the formula involve the computation of EBIT. This is the company's earnings before interest and tax. The first ratio looks at a company's earnings relative to enterprise value. The second ratio looks at a return on capital, or in other words, earnings relative to tangible assets.