Magic Formula Investing

Using Magic Formula Investing to Filter Stocks

Excerpt:

Magic Formula Investing, or MFI, is based on a process, not on hard limits. The process is simply applied on a "basket" of stocks, producing a relative ranking for each stock in that basket based on a composite of earnings yield and adjusted return on capital. The result you get is your basket ranked from 1-N, with lower rankings indicating good companies selling at cheap prices.

The strategy as a whole is usually applied to all U.S.-listed stocks over $50 million market cap, to find the market's most attractive "quality-at-value" opportunities. However, it doesn't have to be used in this manner. It is perfectly viable to apply MFI's tenets to smaller baskets of stocks to compare investment opportunities.

In fact, using MFI buys you a lot of advantages over more traditional price-to-earnings (P/E) and return on equity comparisons:

1. MFI uses enterprise value instead of market capitalization when calculating the earnings yield. This has the effect of penalizing firms with a lot of debt, while at the same time rewarding firms with a lot of cash on the balance sheet.
2. MFI uses operating earnings instead of net earnings when calculating the earnings yield. This eliminates the one-time charges that can distort P/E ratios, and also ignores the effects of unpredictable (and often non-recurring) tax provisions.
3. By using return on *tangible* capital (i.e., subtracting goodwill and intangible assets), and removing excess cash, MFI is comparing most firms on an apples-to-apples basis, instead of relying on some purely accounting assumptions for the value of assets.

Comment: First I've heard of this. Website: Magic Formula Investing. Article compares KO, PEP, and DPS. My own analysis (primative) had KO on top with PEP close second. And DPS out of the running. Magic Formula Investing has DPS as # 1.