GREENBLATT’S MAGIC FORMULA

GREENBLATT’S MAGIC FORMULA is a quantitative translation of Warren Buffett’s investment strategy based on two main factors:

  • a “wonderful” company and
  • a fair price.

Buffett’s vision is to prefer the strategy of buying a “wonderful” company with a fair price rather than buying a fair company with a “wonderful” price. GREENBALTT’S FORMULA introduced solid definitions for the “wonderful company” and “fair price” factors. (cf. Grey/Carlisle 2013, p.36).

A wonderful Business

As defined by Buffet, high return on equity capital is the accurate indication of a successful business. Greenblatt translated this definition into the following formula (cf. Grey/Carlisle 2013, p.36):


Return on Capital (ROC) =

Earnings before interest and taxes (EBIT) / Capital


Capital =

Net property plant and equipment + Net working capital

with

Net Working Capital =

current assets – current liabilities

The ROC measures how efficiently the business capital employed (excluding cash and interest bearing assets) is managed.

A higher ROC is an indication of more revenue generated against capital business employed. (cf. Grey/Carlisle 2013, p.37).

A Fair Price (Bargain Price)

Greenblatt used the following formula to address the price issue (cf. Grey/Carlisle 2013, p.37):

Earnings Yield= EBIT/ TEV

with

EBIT (Earnings before Interest and Taxes)

TEV (Total Enterprise Value) =

market capitalization + total debt – excess cash + preferred stock + minority interests

with

excess cash = cash + current asset – current liabilities

The introduced formula of Earnings Yield takes capital structure into account and enables an apple-to-apple comparison of stocks with different capital structures and avoids any misleading stock calculations resulting from focusing only on earnings from market capitalization. A stock’s market capitalization does not provide accurate information about stock debts or stock preference. (cf. Grey/Carlisle 2013, p.38).

Reference

Grey, Wesley ; Tobias Carlisle (2013): Quantitative Value. A Practioners guide to automating intelligent investment and eliminating behavioral errors. John Wily & Sons. Hoboken, New Jersey.