Hello! The magic formula actually represents a reliance on the 2 metrics of Return on Invested Capital (ROIC) and Earnings Yield. There have been a lot of published studies on the results of applying this formula before, with different variations and results received. You can check those out if you are interested in the results.
I can share roughly about ROIC and earnings yield.
Earnings Yield
The formula used in the book is actually EBIT / EV, which is Earnings Before Interest and Taxes divided by Enterprise Value. EBIT actually is a measure of how much the company has earned, before paying interest and taxes, as the name suggests. Enteprise Value is a measure of the how much the business is worth. EBIT / EV thus stands for the returns that the company has earned based on the value of the business.
EBIT is used because it can be used to compared between different companies which have different amount of interest costs based on the amount of debt they have and different amount of taxes based on different tax regimes.
Enterprise Value is used because it is more representative of the worth of the business, since assets such as cash are excluded which don't typically generate returns for a business.
Return on Capital
The formula employed here is EBIT / (Net Fixed Assets + Working Capital). Net fixed assets is used because it takes away the effect of depreciation, which is a measure of the life span of how long certain fixed assets can last. Working capital is used because it measures the amount of resources that is available through working capital management. This is because some companies could be tied down by higher working capital needs in the form of liabilities, which my reduce their capacity to generate higher earnings.
Hello! The magic formula actually represents a reliance on the 2 metrics of Return on Invested Capital (ROIC) and Earnings Yield. There have been a lot of published studies on the results of applying this formula before, with different variations and results received. You can check those out if you are interested in the results.
I can share roughly about ROIC and earnings yield.
Earnings Yield
The formula used in the book is actually EBIT / EV, which is Earnings Before Interest and Taxes divided by Enterprise Value. EBIT actually is a measure of how much the company has earned, before paying interest and taxes, as the name suggests. Enteprise Value is a measure of the how much the business is worth. EBIT / EV thus stands for the returns that the company has earned based on the value of the business.
EBIT is used because it can be used to compared between different companies which have different amount of interest costs based on the amount of debt they have and different amount of taxes based on different tax regimes.
Enterprise Value is used because it is more representative of the worth of the business, since assets such as cash are excluded which don't typically generate returns for a business.
Return on Capital
The formula employed here is EBIT / (Net Fixed Assets + Working Capital). Net fixed assets is used because it takes away the effect of depreciation, which is a measure of the life span of how long certain fixed assets can last. Working capital is used because it measures the amount of resources that is available through working capital management. This is because some companies could be tied down by higher working capital needs in the form of liabilities, which my reduce their capacity to generate higher earnings.