Joel Greenblatt's Magic Formula, as described in
The Little Book that Beats the Market relies on ranking stocks based on two simple concepts. The first one measures the quality of the business: return on capital, a concept I've covered in a previous article. The second statistic measures how cheap a stock is against trailing earnings: earnings yield. But what is earnings yield? It's not easily available in any run-of-the-mill stock screener. And why not use the more ubiquitous P/E ratio when valuing stocks against trailing earnings?
The first thing we need to cover is how to calculate earnings yield. To do this, we'll first look at the simple way, and then examine how Greenblatt devised his earnings yield calculation for ranking stocks for the Magic Formula screens. The simple way is just so, simply taking the inverse of the P/E ratio and turning it into a percentage:
Earnings Yield = Net Profit / Market Cap
So, for example, a stock with a P/E ratio of 5 has an earnings yield of 1/5, which is 0.20, or 20%.
By turning P/E into a percentage we've already accomplished something useful. In theory, this percentage represents the return on every dollar invested that should be earned by the company, assuming earnings remain flat (a questionable assumption to be sure). This percentage can then be compared directly against the returns offered by alternative investments, such as interest on a bond or savings account. The utility is greater than that provided by the P/E ratio. This is one reason why earnings yield is better than P/E.
Magic Formula earnings yield is a bit more complicated than this. The formula used by Greenblatt to rank stocks is:
MFI Earnings Yield = Operating Earnings / Enterprise Value
One side of this, enterprise value, was discussed in detail in the article linked here. Using enterprise value penalizes companies that carry a lot of debt and little cash, and rewards firms with a lot of cash and little if any debt - a useful distinction not reflected in the P/E ratio. Enterprise value is lower than market cap when a firm carries more cash then it has in debt, and higher than market cap when the debt burden is higher than cash, meaning earnings yield will be higher in the former case, given a constant value for operating earnings.
Operating earnings is simply profits before non-operating items like interest, goodwill write-offs, taxes, and so forth. This is also referred to as "earnings before interest and taxes", or EBIT.
