Magic Formula

1. Calculate Earnings Yield = EBIT / enterprise value.

2. Calculate Return on Capital = EBIT / (Net fixed assets + working capital)
3. EY Rank: Rank the stocks in descending order based on Earnings Yield and assign a rank
number to each.
4. ROC Rank: Rank the same stocks in descending order based on Return on Capital and assign a
rank number to each.
5. Add the rankings and select stocks that have the lowest combined ranking score.

Calculation / Definition of the Magic Formula
Define minimum Market Capitalization that meets your liquidity needs. Greenblatt used a market
capitalization floor of $50 million, but advised that you can set the minimum as high as $5 billion.
Sector Filter: Due to their unique financial structures, all stocks in the financial and utility sectors are
excluded.
Calculate Earnings Yield = EBIT / enterprise value.
Calculate Return on Capital = EBIT / (Net fixed assets + working capital)
EY Rank: Rank the stocks in descending order based on Earnings Yield and assign a rank number to each.
ROC Rank: Rank the same stocks in descending order based on Return on Capital and assign a rank
number to each.
Add the rankings and select stocks that have the lowest combined ranking score. So a company that is
ranked 358nd best in terms of ROC and 122rd highest in EY would gets a better combined ranking (i.e. 470)
than a company that is ranked 1st in ROIC but only 950th best in EY (i.e. 951).
As noted elsewhere, one of the advantages of the MFIs relative approach is that the system never runs out
of investment candidates. Several value investment strategies have become de facto obsolete over time. For
example, whereas Ben Graham successfully searched for so-called net nets more than a half-century ago,
such companies have become virtually extinct today. By contrast, MFI simply ranks public companies relative
to each other. There is no absolute cheapness requirement.
Geek Stuff
Here are the key definitions in general, trailing twelve month numbers from the income statement are used or
the latest quarterly numbers for balance sheet figures.
Enterprise value = Equity market value of equity (including preferred stock) + interest-bearing debt -
excess cash. If the returned value for Enterprise value is negative, then a default value of 0 is used.
EBIT = Pretax Income + Interest Expense.
ROC = EBIT / (Net Working Capital + Net Fixed assets)
Net Fixed Assets (or property, plant and equipment after depreciation) = Total Assets - Total Current
Assets - Total Intangible assets/goodwill
Net Working Capital = Max(Total Current Assets - Excess cash - Non-interest Bearing Payables,0). A
maximum function is used as Joel Greenblatt has hinted that he uses zero when net working capital is
negative.
Non-interest bearing payables = Total Current Liability Interest Bearing Payables (i.e., short-term debt).
This is one way to estimate NIBP via deduction, unless it is directly available.
Excess Cash = Max(Total Cash LTM Sales * 5%, 0). Excess cash is a matter of debate, since Joel
Greenblatt has not answered any questions regarding how this is calculated. The cash to sales ratio seems
to be the most common measurement of needed cash, with the ratio typically in the 3% to 10% of sales,
hence 5% is used as a blended average. Another approach advocated here is Excess Cash = Total Cash -
MAX(0; (Current Liabilities - Current Assets + Total Cash))
The calculation of Return on Capital has several definitions depending on the source used. At Stockopedia we
distinguish between the following three different methods of calculation:
1. ROCE - 'Return on Capital Employed' - a plain vanilla version as reported on the StockReports, In the
case of ROCE, the numerator is operating income and the denominator is 'capital employed' instead of
total assets as in ROA. Capital Employed has many definitions unfortunately, but, in general it is the
capital investment necessary for a business to function, often defined as fixed assets plus working
capital, or total assets less current liabilities (which is what we use).

2. ROCE Greenblatt. This uses a specific definition of Return on Capital Employed based on Joel
Greenblatts Magic Formula book (which is a quick and very good read that discusses return on capital
in depth). As denominator it uses the sum of 'Net Working Capital' and 'Net Fixed Assets'. Net
Working Capital excludes excess cash and 'non interest bearing payables', while Net Fixed Assets
excludes goodwill and intangibles. These adjustments are quite specific and designed to come to a
closer approximation of the genuine capital employed in the operating enterprise of the company .They
are discussed in more detail in this article.

3. ROIC 'Return on Invested Capital' - a popular term more often used in the USA. In the case of ROIC,
the calculation used is 'Net operating income after tax' / Invested Capital where Invested Capital = Total
Equity + Total Liabilities Current Liabilities Excess Cash. (We use the Greenblatt definition of
Excess Cash as cash at hand in excess of 5% of revenues).

Enterprise Value
Enterprise value (EV), also called firm value or total enterprise value (TEV), tells us how much a business is
worth. You can calculate enterprise value using a number of valuation techniques like discounted cash flow
(DCF) analysis, but for now we'll simply calculate EV as follows:
EV = Equity Value + Net Debt + Non Controlling Interest + Preferred Stock + Capital Leases
Enterprise value is the theoretical price an acquirer might pay for another firm, and is useful in comparing firms with
different capital structures since the value of a firm is unaffected by its choice of capital structure.
Equity Value
A public company's equity value, or market capitalization, is shareholders' residual interest after paying off all
senior claims such as debt and preferred stock. It is calculated as the current share price multiplied by the
number of diluted shares outstanding. To calculate diluted shares, you need to first find the number of basic
shares on the front of the latest company SEC filing (e.g. 10-K, 10-Q, 20-F). Add to that number any restricted
shares and net shares resulting from the exercise or conversion of options, warrants, and convertible securities
to get diluted shares outstanding.
The net share equivalents resulting from the exercise of options is calculated using the treasury method:
Assumes that proceeds from the exercise of options are used to repurchase shares at the current
market price
Net share equivalents = options (options exercise price current market price)
Includes all outstanding in-the-money (ITM) options, whether vested or not
Convertible securities, which can be debt or preferred stock, are convertible into common shares at a specific
stock price known as the conversion price or strike price or exercise price. Only in-the-money (ITM) convertible
securities impact diluted share count.
If the current stock price is greater than the conversion price, the convertibles are ITM
ITM convertible securities increase the number of shares outstanding by the amount of new shares
issued upon conversion
New shares issued = face value of ITM convertibles conversion price
Upon conversion, the face value of ITM convertibles is subtracted from debt or preferred stock, as
appropriate, and added to common equity
When a convertible security has a fixed coupon interest payment, determining whether or not the security is
ITM can be complicated. In these cases, add the present value of all future interest payments (per share) to
the conversion price and compare the sum to the current stock price.
Net Debt
Net debt is equal to total debt less cash and cash equivalents. When calculating total debt, be sure to include
both the long-term debt and the current portion of long-term debt, or short-term debt. Any in-the-money (ITM)
convertible debt is treated as if converted to equity and is not considered debt.
When calculating cash and equivalents, you should include such balance sheet items as Available for Sale
Securities and Marketable Securities, even if they are not classified as current assets on the balance sheet. Do
not include restricted cash in this calculation. Restricted cash is not often explicitly identified on the balance
sheet, but can be estimated as a percent of cash and equivalents depending on the industry, for example. In
practice, however, we generally ignore restricted cash unless it is explicitly identified on the balance sheet or
elsewhere in company filings.
The market value of debt should be used in the calculation of enterprise value. However, in practice we can
usually use the book value of the debt by assuming that the debt trades at par. This assumption would be
inappropriate in the valuation of distressed companies, whose debt will trade significantly below par.
In practice, noncontrolling interest, preferred equity not convertible into common stock, and capital leases are
sometimes bundled into the net debt calculation. We will assume net debt includes these components when
we refer to it in our coverage of valuation topics.
Noncontrolling (Minority) Interest
Noncontrolling interest, formerly known as minority interest, represents the interest of noncontrolling
shareholders in the net assets of a company and is reported in the shareholders' equity section of the balance
sheet (or in the "mezzanize section" between liabilities and equity prior to FAS 141r). For example, a parent
company might have an 80% controlling interest in a consolidated subsidiary, while the remaining 20%
noncontrolling interest is owned by another company. If noncontrolling interest is excluded from the calculation
of enterprise value, the consolidated EBITDA, EBIT, etc. should be similarly adjusted to exclude the portion not
attributable to the parent company.
Preferred Stock
Preferred equity that is not convertible into common stock is treated as a financial liability equal to its
liquidation value and included in net debt. Liquidation value is the amount the firm must pay to eliminate the
obligation.















Calculation / Definition of F-Score
Piotroski's approach essentially looks for companies that are profit-making, have improving margins, don't employ any accounting tricks
and have strengthening balance sheets. The nine variables are split into three groups:
A. Profitability Signals
1. Net Income Score 1 if there is positive net income in the current year.
2. Operating Cash Flow Score 1 if there is positive cashflow from operations in the current year.
3. Return on Assets Score 1 if the ROA is higher in the current period compared to the previous year.
4. Quality of Earnings Score 1 if the cash flow from operations exceeds net income before extraordinary items.
B. Leverage, Liquidity and Source of Funds
5. Decrease in leverage Score 1 if there is a lower ratio of long term debt to in the current period compared value in the previous
year .
6. Increase in liquidity Score 1 if there is a higher current ratio this year compared to the previous year.
7. Absence of Dilution Score 1 if the Firm did not issue new shares/equity in the preceding year.
C. Operating Efficiency
8. Score 1 if there is a higher gross margin compared to the previous year.
9. Asset Turnover Score 1 if there is a higher asset turnover ratio year on year (as a measure of productivity).









Montier's C-Score: Are your favourite stocks cooking the books?
Last week, we looked at James Montier's three-pronged approach to shorting stocks. Following on from that, it's also worth mentioning
a useful accounting test that he developed in the context of shorting called the C-Score (C apparently stands for cheating or cooking the
books). It's similar in nature to the Beneish M-Score, i.e. it's focused on identifying tell-tale signs / quantitative red flags which
accompany bad accounting practice.
Even if you don't fancy shorting individual stocks (given the scope for unlimited loss!), the C-Score approach is still a useful tool as a
red flag that's worth knowing about - as with the Altman Z-Score, we're considering adding it as part of the Stockopedia Premium Stock
Report.
How does it work?
Montier's C-Score is made up of six red flags or warning signals. The idea is that, like the Piotroski F-Score for financial health, these
elements are scored in a simple binary fashion, 1 for yes, 0 for no.
These scores are then summed across the elements to give a final C-score ranging from 0 (no evidence of earnings manipulation) to 6
(all the flags are present - yikes!). The areas tested are:
1. Is there a growing divergence between net income and operating cash-flow? We've talked elsewhere about the fact that
management have less flexibility to alter cash flow, whereas earnings can be stuffed for all sorts of "funnies", so this is
something to watch for.
2. Are Days Sales Outstanding (DSO) increasing? If so (i.e. accounts receivable are growing faster than sales), this may be a
sign of channel stuffing.
3. Are days sales of inventory (DSI) increasing? If so, this may suggest slowing sales, not a good sign.
4. Are other current assets increasing vs revenues? As some CFOs know that DSO and/or DSI are usually closely watched,
they may use this catch-all line item to help hide things they dont want investors to focus upon.
5. Are there declines in depreciation relative to gross property plant and equipment? This guards against firms altering
their estimate of useful asset life to beat earnings targets.
6. Is total asset growth high? Some firms are serial acquirers and use their acquisitions to distort their earnings. While this may
be justified in some circumstance, generally it has been shown that high asset growth firms underperform. It's not clear what
Montier defines as "high" but we're assuming that firms with above average asset growth would qualify as 1.
Of course, any of these elements on their own may be perfectly innocent, but it's probably worth knowing the explanation for it before
you invest. The idea is that, the more flags that are present, the more likely it is that something may be going on below the surface of
the accounts. Having said that, Montier's original list from 2008 contains some fairly respectable names like Amazon - so beware of
false positives, as with any statistical measure.
Does it work?
Montier found that, in the US, stocks with high C-scores underperformed the market by around 8% p.a., generating an absolute return
of just 1.8%. In Europe, high C-score stocks underperformed the market by around 5% p.a., although, interestingly, they still generated
absolute returns of around 8% p.a...
As a shorting tool then, Montier suggests using the C-Score in combination with some measure of over-valuation. This was on the
basis that high-flying and generally more expensive stocks that are tempted to alter their earnings in order to maintain their high growth
status. He used a threshold price to sales ratio of 2 and found that this drove the absolute return down to -4% in both the US and
Europe!