Overall the book is very simplistic and easy to understand for people of any walk of life, even without education in finance.

 

Through examples of an imaginary character Jason and his gum stores as well as Mr.Market (a character invented by Benjamin Graham) he explains what business are worth and what the market is ready to pay for it. Very often these two numbers do not match.

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Hence he introduces the Magic Formula which ranks the business with the best return on capital and the highest earning yield. In other words - above-average business at below-average prices

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Magic formula:

 

• Buy business with high return on capital and high earnings yield

  • Return on capital = EBIT[DA] / (Net Working Capital + Net Fixed Assets)

    • Net working capital + Net Fixed Assets = Tangible equity = Equity - intangible assets

  • Earnings yield = E/P - the inverse of PE ratio

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The author ranks 3500 largest companies in the US in a combined ratio and selects top 30 of them in every quarter.

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While sounds simple, it is in fact difficult to stick to it as it might produce fluctuations and in some cases underperform the market. Therefore a long-term approach (5 years or more) should be taken when applying this formula.

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The updated version of the book provides a back-test of the formula from 1988 to 2009, where it produces the following results

• Largest 1000 stocks (over $1bn market cap) +19.7% p.a.

• Largest 3500 stocks (over $50m market cap) +23.8% p.a.

• S&P 500 index + 9.5% p.a

 

The author provides a free online resource for the selection of the top companies base on the formula in his website: https://www.magicformulainvesting.com/

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An independent back-test confirms the outperformance of the strategy, however over extended periods of time the strategy might underperform.

https://reasonabledeviations.com/2020/06/08/greenblatt-magic-formula/

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