The Magic Formula seeks to identify “good” businesses selling at “bargain” prices. It uses two factors to rank stocks so that you can identify the best businesses selling at bargain prices.
The first factor identifies a good business as one that produces a high return on capital (ROC). Return on capital is calculated by dividing earnings before interest and taxes (EBIT) by the sum of net working capital and net fixed assets.
ROC = EBIT / (Net Working Capital + Net Fixed assets)
The second factor identifies businesses selling at bargain prices by examining earnings yield, which is basically the in inverse of the price earnings ratio (P/E). More specifically, earnings yield is defined as earnings before interest and taxes divided by enterprise value.
EY = EBIT/EV