The Little Book: That Still Beats the Market

Chapter 11. Chapter Eleven

SO THE MAGIC FORMULA ISN'T YOUR THING. The high returns, the low risk, the simplicity, the logic—these things mean nothing to you. You want—in fact, you need—to pick stocks all by yourself! No one, and especially no silly formula, is going to stand in your way. You're out there on the ledge, and there's no use talking you down! Don't worry. I get it, and that's just fine. But to borrow from something I once wrote, remember this:

Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot.

So how can you pick stocks intelligently? What should you be looking for? Even if you've decided not to follow the magic formula, how can you still use it to keep from blowing yourself up? Well, glad you asked. Let's see.

As we already know, the magic formula picks stocks that have both a high earnings yield and a high return on capital. For earnings yield, the formula looks for companies that earn a lot compared to the price we have to pay. For return on capital, the formula looks for companies that earn a lot compared to how much the company has to pay to buy the assets that created those earnings. To calculate these ratios, the magic formula doesn't look at future earnings. That's too hard. The magic formula uses last year's earnings.

The funny thing is, that seems like the wrong thing to do. The value of a company comes from how much money it will earn for ...