To do this, let's first quickly review the screening method used by Magic Formula Investing. There are two variables. The first is earnings yield, which is a modified valuation statistic similar to the P/E ratio. It measures how cheap a stock is relative to trailing earnings. The second variable is return on invested capital, which measures the return a company earns on the money it invests into the business. All non-financial and non-utility U.S. traded stocks are scored on these two variables and ranked from highest to lowest on each. The rankings are then added together and, voila!, the MFI screens are created. The idea is that the highest ranked stocks are the best businesses (highest returns on capital) at the cheapest prices (highest earnings yield) available on the market today.

It's the second variable, return on invested capital, that we'll focus on here. Traditionally, return on invested capital measures the post-tax profit earned on net assets used in running the business, not including "extra" assets like excess cash and investments (more details in this article). However, Greenblatt made a few modifications to the MFI return on capital calculation to account for what he perceived as misleading differences between businesses:

1) MFI uses pre-tax operating earnings instead of post-tax. The reason for this is to remove the differences in tax rates between different businesses. For example, a company like Resources Global Professionals (NasdaqGS: RECN) that does the majority of business in the United States pays a tax rate over 40%, while a company like Western Digital (NYSE: WDC), who generates most earnings and pays most costs in Asia, pays a tax rate in the single digits. By removing tax effects, you get a better picture of the efficiency of the business itself, without being skewed by non-operating related aspects.