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Joel Greenblatt's magic formula, as described in the book that beats the market is based on the populations of the classification based on two simple concepts. The first measure the quality of the company: the return on equity, a concept I discussed in a previous article. The statistical measures second how economic it is against the action behind the revenue: revenue performance. But what are the performance of income? Not readily available in all enforcement actions the-mill – blocking. And why not use the most ubiquitous P / E to evaluate the procedure ends profits?

The first thing we have ahead is how to calculate performance gains. To do this, first analyze how The simplest, and then examine how Greenblatt has developed his method of performance gains for stocks for the classification of screen magic. The most simple, it is simply taking the inverse of the P / E and make a percentage:

Performance = Net Income / Market Value

For example, a stock with a P / E of 5 has an output benefit of 1 / 5, which is 0.20, or 20%.

Turning P / E at a rate we have done something useful. In theory, this ratio represents the return of every dollar spent must be won by the company, assuming revenues remain flat (a questionable assumption to be sure). This percentage is comparable directly against the returns offered by investments alternative, such as interest on a bond or savings account. The utility is greater than that provided by the P / E. This is one reason where performance gains are better than P / E.

Magic Formula Performance income is slightly more complicated than that. The formula used by Greenblatt to classify stocks as follows:

Earnings Yield MFI = Operating profit / value of the company

One side this, the value of the company, was discussed in detail in the related article here. Using the value of the company penalizes companies who have many debts and little money, and reward companies with big money and little or no debt – a useful distinction is not reflected in the P / E. Enterprise value is less than the market capitalization when a company makes more money then he has a debt, and higher than the market capitalization when the debt is larger than the species, ie the revenue yield will be higher In the first case, given a constant value of operating income.

Operating income is more than the benefits before non-operating items such as interest, amortization of goodwill, taxes and so on. This is also known as "earnings before interest and taxes, or EBIT. By using operating income instead of the network, you get a better picture of profits at the company without the distortions caused by tax benefits recognized or severe impairment of goodwill that have little to do with profitability.

It is always interesting to go through a small example that illustrates the value of how the magic formula to things. We will use these values MFI Pacer International (PACR). Pacer certainly not in the P / E screens, and net income for the last 12 month is dollar negative 208 million! In a current market capitalization of 143 million dollars, the P / E would be about -0.7.

But in this case, P / E is misleading – Pacer over the last 12 months is both a profitability and positive cash flow. Magic formula to calculate the earnings yield, First find the value of the company. For more details on how to calculate, see the value of the company named above.

Enterprise Value = Market Cap + Debt – Cash Surplus

= $ 143 + $ 80 – $ 5 = $ 218 million value of the company

Now we look at the operating result and see the hard part: approximately 290 million dollars in the account of amortization of goodwill loss net for all. While the amortization of goodwill are not a good thing (which indicates an overpayment for acquisitions the past), does not include the actual loss of functioning in cash. Besides these taxes, interest and /, Pacer has allocated 42.4 million U.S. dollars operating profit last year. Thus, the company is really profitable during this period of time, despite what the P / E said.

Using the value we can find the revenue performance of MFIs:

= $ 42.4 / $ 218 = 0.195 or earnings yield 19.5%

This performance gains rate is far better than anything you can get a premium or a CD, but with actions that further analysis is necessary. For example, just Pacer to each state where sales fell by 30%, which recorded an operating loss of $ 23 million, and had to assume additional debt due to liquidity problems.

Steven Alexander is the founder and voice behind MagicDiligence (http://www.magicdiligence.com). Joel Greenblatt’s Magic Formula Investing (MFI) strategy delivered over 30% annual returns over a 17 year period, but includes many fad stocks, cyclical commodity plays, and dying businesses. MagicDiligence researches the stocks on the MFI screen to weed out these undesirables and recommend only the very best stocks, with outstanding results. Try a FREE 30-day trial and start investing successfully and independently today!