As silly as it may sound, the "magic formula" stock screen is actually quite serious. Its effectiveness lies in its simplicity. The formula incorporates two key variables in screening for its stocks. The first is the earnings yield, which the inverse of the P/E ratio; the second is return on capital invested. A business that has both a high earnings yield and a high ROIC is clearly doing something right. More so, a business than can earn above average earnings and an ROIC for a period of years is very likely to create value for investors.
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The Big Names
Running this screen produced a diverse group of names, both big and small. The biggest on the list was Microsoft (Nasdaq:MSFT). At the current share price of $26, MSFT trades for 9.5 times forward earnings or an earnings yield of 10.5%. In addition the company sports an ROE of over 40%. Since the company has minimal debt, ROIC is nearly as high. Defense company Raytheon (NYSE:RTN) is another name that appears on the list. Raytheon is a $17 billion maker of major defense and aerospace systems and a major contractor the U.S. Dept of Defense. Raytheon's earnings yield is over 12%. The company has no net debt and return on capital invested exceeds 15%. (For more, see Greenblatt's Little Book Loves McGraw-Hill.)
The Lesser Known
Online pet pharmacy PetMed Express (Nasdaq:PETS) also shows up on the list. PETS sports a market cap of $337 million a P/E ratio of 15, or an earnings yield of just under 7%. The company has over $70 million in cash on the balance sheet and no debt. The company has an unlevered return on equity of 23% and has a dividend yield of over 3%.
Chinese pharmaceuticals company Jiangbo Pharmaceuticals (NYSE:JGBO) may look too good to be true. JGBO owns and operates small local pharmacies throughout China. The company has a market cap of $64 million, $134 million in cash on the balance sheet and total liabilities of $56 million. Recently, there has been a lot of negative news regarding Chinese small cap companies trading in the U.S. and the reliability of their financial statements. JGBO has come under no such scrutiny but investors should know that the company's CFO resigned back in March. (For more, see The Value Investor's Handbook.)
As effective as it is, the magic formula does have limitations. A company with one good year of results could show up on the screen and disappear thereafter, never to return. Investors should be mindful of this when using the magic formula for ideas. (For further reading, check out Stocks With A Little Magic.)
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