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:
- 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.
- 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.
- 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.