IMPORTANT NOTICE: This appendix is not required reading. To utilize the magic formula strategy successfully, you must understand only two basic concepts. First, buying good companies at bargain prices makes sense. On average, this is what the magic formula does. Second, it can take Mr. Market several years to recognize a bargain. Therefore, the magic formula strategy requires patience. The information that follows in this section is merely additional commentary on these two points.
This appendix includes background information about the magic formula for those with a higher level of understanding of financial statements. It also compares the logic and results of the magic formula strategy with other studies and methods that have demonstrated an ability to beat the market.
The magic formula ranks companies based on two factors: return on capital and earnings yield. These factors can be measured in several different ways. The measures chosen for the study in this book are described in more detail as follows:
EBIT/(Net Working Capital + Net Fixed Assets)
Return on capital was measured by calculating the ratio of pre tax operating earnings (EBIT) to tangible capital employed (Net Working Capital + Net Fixed Assets). This ratio was used rather than the more commonly used ratios of return on equity (ROE, earnings/equity) or return on assets (ROA, earnings/assets) for several reasons.
EBIT (or earnings before interest and taxes ...