Joel Greenblatt’s magic formula for investing in the stock market

The magic formula for investing in Joel Greenblatt's stock marketRecently in this blog I recommended "the little book that beats the market”, Written by famous investor and popularizer Joel Greenblatt. As I already told you, in this book he teaches us his magic formula to beat the market safely and consistently. In this article we will analyze Joel Greenblatt's magic formula for investing in the stock market, we will see how to use it and also its drawbacks for small investors.

Understanding the magic formula for investing in the stock market from Joel Greenblatt

Before applying Joel Greenblatt's magic formula, I think it is highly recommended, even necessary, to understand why it works.

The magic formula looks for companies that excel in two respects: return on equity and profit-to-price ratio. In other words, Greenblatt seeks to pay little for companies that generate good returns to their shareholders, which is in theory what all investors who rely on it should look for. value investing to invest in the stock market. This is the reason why this formula manages to beat the market in a sustained way over time.

There are many ways to measure both the return on capital in a company and its relationship between price and profit. Among others, we could use ROA or ROE to measure performance and PER or P / FCF to measure the relationship between price and profit, which are the most common metrics that are usually used in these cases. However, Greenblatt prefers to use other metrics in his magic formula that we will see below.

How does the magic formula measure return on equity?

The ratio that Greenblatt uses in his magic formula to measure return on capital is the one that results from dividing the EBIT ("Earnings Before Interests and Taxes" or "Profit Before Interest and Taxes") by tangible net assets, which is the sum of net working capital and net fixed assets.

Return on Capital = EBIT / Net Tangible Assets

The decision to use EBIT instead of net profit comes from a willingness to disregard debt interest and tax rates and focus on pure profit for the company.

The formula uses Tangible Net Assets instead of Total Assets (as in ROA) or Equity (as in ROE), because the formula focuses solely on the return on working capital that the company needs to carry out carry out your operations. That is why intangible assets, such as goodwill, are excluded from the formula.

How does the magic formula measure the profit-price ratio?

The most common way to measure the relationship between the profit of a company is the Another reason, which we already analyzed in this blog. However, the magic formula does not use the relationship between price and net profit, but another much more used especially when valuing corporate operations:

Profit-price ratio = EBIT / Company Value

Again, the company uses EBIT instead of net profit to measure profitability, while it uses the company value instead of the capitalization bursátil because, as I have shown you on the blog, it is a much more complete metric than capitalization since it also takes into account the net financial position of the company and the best estimate of the total cost that the acquisition of the entire company would entail when Actual Price.

An easier way to apply Greenblatt's magic formula

You may find it quite difficult to calculate the return on equity and the earnings-price ratio of all stocks, and then rank them. I understand. For you, there is a much easier (and free) way to get the shares to invest in according to the Greenblatt magic formula. In the web you have a free selector that looks for companies that conform to the requirements of the magic formula.

The only catch is that this method only works for US stocks. So I encourage Joel Greenblatt and his team to do something similar for stocks of companies listed in markets around the world.

The drawbacks of the magic formula

First, although it seems like a simple investment method, it is not so simple. To apply the formula to shares listed on the Spanish stock market (or any stock exchange other than the US one) we must perform the calculations ourselves. It is not a big drawback, but it is a small inconvenience.

The main problem with the magic formula lies in the taxation of small investors. While investment funds in their efforts do not pay taxes on the capital gains of their purchases, private investors must pay taxes every time they generate a profit. This is the reason why I normally recommend to most investors that they invest in funds, because of the tax burden, for me unfair, that we must bear.

The ideal would be an investment fund that replicates the magic formula, since we would only pay taxes on capital gains if we decided to sell our participation in the investment fund, without having to go through the cashier once a year when making the necessary stock sales so that the magic formula works, that is, investing directly in the funds managed by Greenblatt.