NEW YORK ( MagicDiligence.com) -- Magic Formula Investing, or MFI, is based on a process, not on hard limits.

One takes a basket of stocks and ranks them based on a composite of earnings yield and adjusted return on capital. Lower rankings indicate good companies selling at cheap prices.

Typically, the strategy is applied to all U.S.-listed stocks with market caps of more than $50 million in order 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 valid to apply MFI's tenets to smaller baskets of stocks to compare investment opportunities.

In fact, using MFI gives 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 to calculate earnings yield. This penalizes firms with a lot of debt and rewards those with a lot of cash on the balance sheet.
  2. MFI uses operating earnings instead of net earnings to calculate earnings yield. This eliminates the one-time charges that can distort P/E ratios and ignores the effects of unpredictable (and often nonrecurring) tax provisions.
  3. By using return on "tangible" capital (i.e., subtracting goodwill and intangible assets) and removing excess cash, MFI compares most firms on an apples-to-apples basis, instead of relying on accounting assumptions for the value of assets.

With this in mind, let's look at a few examples of using MFI to compare investment opportunities. All of these examples were generated with MagicDiligence's Portfolio Stats Calculator.

Case No. 1: The Pepsi Challenge

Let's start with a very simple comparison: the three major soda makers ( Dr. Pepper Snapple ( DPS), PepsiCo ( PEP) and Coca-Cola ( KO)). Which has the best combination of high return on capital and a low stock price? (Taste was not considered.)

Dr. Pepper Snapple Group wins pretty handily, taking both the highest earnings yield and highest returns on capital. PepsiCo comes in second, and Coca-Cola comes in last with both the lowest earnings yield and return on capital.

Note that "current ratio," or "CR" is a measure of financial health. Higher values are better. Typically, you want to see 1.0 or higher.

Case No. 2: Large Retailers

Using MFI stats to compare a larger group of rivals is useful, too. Although there really are only three major soda makers, there is a larger number of big retailers. Say you want to add some retail exposure to your portfolio, but your are unsure about which stock(s) to add? Let's take a look at a bunch of them, ranked in the MFI manner:

A few things stand out here. One, most of the large retailers look pretty cheap, with earnings yields of 9% or higher (you can compare earnings yield to a bond or CD). Second, this industry is not particularly capital efficient, with returns on tangible capital in the 10%-20% range. Most "official" Magic Formula stocks boast returns on tangible capital of 50% or higher.

In this group, Kohl's ( KSS) is the winner, with the cheapest stock price and most efficient operations. The middle is pretty bunched up, while Saks ( SKS) and Sears ( SHLD) bring up the rear. Prospective investors would have to justify Sears' weak profitability and fairly high valuation. Is Eddie Lampert's name really worth it?

Case No. 3: The Dow 30

The method can also be applied to the popular indices. To keep the example simple, we'll use the smallest of them, the Dow Jones Industrial Average, which has only 30 members. Here they are:

The Dow tech stocks dominate. These are and have been very profitable firms, and the recent selloff in tech has made them attractive on a valuation basis. Several of these are screened into the "official" Magic Formula lists right now.

Also, some readers may notice that four of the Dow stocks are missing: American Express ( AXP), Bank of America ( BAC), JPMorgan ( JPM) and Travelers ( TRV). The method of ranking unfortunately does not work for financial stocks such as banks and insurance companies.

Conclusion

Ranking groups of stocks using the Magic Formula method is an effective way of finding the most attractive investing opportunities. However, it's not perfect. For one thing, it doesn't consider dividend yield or future expected earnings. Nevertheless, it's a meaningful way to narrow one's choices.

At the time of publication, Alexander held shares of Microsoft.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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