Improved Magic Formula Investing Screen with MSN Deluxe Screener

In Magic Formula Investing, I proposed a MSN screen using Return On Invested Capital ROIC and Price/Earnings Ratio PE to emulate Joel Greenblatt's popular strategy.

This article attempts to improve the screen.

In fact, Greenblatt's definition of ROIC and PE are different from MSN. We'll attempt to approximate Greenblatt's parameters with MSN screener. We'll also add few more optimizations.

If you don't like maths and/or financial statements, jump right there

Return On Invested Capital ROIC Formula

- MSN's Return On Invested Capital uses the following formula:
Net Income / (Common Stock Equity + Preferred Equity + Long Term Debt)

- Greenblatt's Return On Invested Capital uses:
EBIT / (Net Working Capital + Net Fixed Assets)

We'll assume the denominators are similar in both formulas.
However, there are clear differences between Net Income and EBIT.

Let's try to compute something close to EBIT with MSN's variables.

We can approximate
PreTax Income = EBIT - Interest Expenses = EBIT * ( 1 - Interest Expense / EBIT )

Interest Expense / EBIT is the reverse of Interest Coverage.
So we can re-write PreTax Income = EBIT * ( 1 - 1 / Interest Coverage )

In addition, PreTax Income = Net Income * PreTax Margin / Net Margin.
Therefore
EBIT = Net Income * PreTax Margin / [ Net Margin * ( 1 - 1 / Interest Coverage ) ]

Greenblatt's ROIC can then be approximated in MSN Deluxe Screener with the following formula (the parameters on the right side of the equation are all available in MSN):

	*Return On Invested Capital PreTax Margin**
MSN ROIC =	---------------------------------------------
	*Net Margin ( 1 - 1 / Interest Coverage )**

Earning Yield EY Formula Go back to Top

Greenblatt's Earning Yield EY is very different than simply 1/PE.
Greenblatt EY = EBIT / (Market value of Stocks & Preferred Equity + Net Interest-Bearing Debt)

It's not possible to obtain Market Value of Preferred Equity nor Net Interest-Bearing Debt with MSN.
So we will use (Market Cap + Debt) for the denominator and we'll build:
MSN Earning Yield EY = EBIT / ( Market Cap + Debt )

Again, we'll do some maths to manipulate the formula.

MSN EY = ( EBIT/Revenue ) / (Market Cap/Revenue + Debt/Revenue ) (1)

We can recognize Price/Sales ratio for the 1st term of the denominator.
Market Cap/Revenue = Price/Sales (2)

The 2nd term of the denominator can be re-written as follows:
Debt/Revenue = ( Debt/Equity ) * ( Equity/Net Income ) * ( Net Income/Revenue )
or
Debt/Revenue = Debt/Equity * 1/ROE * Net Profit Margin (3)

For the numerator, we can divide both sides of the above EBIT equation by Revenue to get:
EBIT/Revenue = PreTax Margin / ( 1 - 1 / Interest Coverage ) (4)

Combining equations (2), (3) and (4) into (1) yields the following:

	[ PreTax Margin / ( 1 - 1 / Interest Coverage ) ]
MSN EY =	--------------------------------------------------------
	*[ Price/Sales + Debt/Equity Net Profit Margin / ROE ]**

Ranking Go back to Top

The old MSN screen uses PE/ROIC to rank stocks as MSN cannot perform double ranking:

Combining the above 2 equations, we get (remember that PE=1/EY):

	*[ Price/Sales + Debt/Equity Net Profit Margin / ROE ] * Net Profit Margin**
PE/ROIC =	---------------------------------------------------------------------------
	*Return On Invested Capital [ PreTax Margin / ( 1 - 1 / Interest Coverage ) ]^2**

When I tried to enter this formula in the Field Name of the Deluxe screener, I (unsurprisingly) got a message that the formula was too complex.

We will therefore neglect the term (1 - 1 / interest coverage)^2, after noticing that Interest Coverage is typically >> 1 so (1 - 1 / Interest Coverage)^2 is close to 1.

Our Ranking parameter will therefore be:

	*[ Price/Sales + Debt/Equity Net Profit Margin / ROE ] * Net Profit Margin**
PE/ROIC =	---------------------------------------------------------------------------
	*Return On Invested Capital PreTax Margin ^2**

The formula is still complex but MSN amazingly accepts it !

Tip: you can check Build Advanced Formulas with MSN Stock Screener for a guide to build advanced formulas with the MSN Stock Screener.

Further Optimizations Go back to Top

In the original MSN screen, I set an upper 50% threshold for the ROIC in order to remove some Financials/Trusts that make it to the top of the screen (Greenblatt specifically removes them).

In addition, the MSN Screen highlights quite a few stocks trading in the OTC while Greenblatt's picks are essentially trading on the NYSE, AMEX and NASDAQ.

Now, here are few things I've noticed:

the Financials/Trusts companies occupying the top places have 0-3 employees only

the companies trading in the OTC exchange have low trading volume

I will therefore make the following changes:

Remove the 50% Upper limit for Return On Invested Capital

Add Number of Employees ≥10 (to filter out Financials/Trusts)

Add Avg Trading Volume in Last month ≥10,000 (to filter out OTC)

Set some boundaries to the Earning Yield to avoid too high and too low PE

Conclusion Go back to Top

The changes from the Old Magic Formula Investing Screen are:

Improve ROIC and EY (= 1/PE) formulas

Remove the Upper 50% limit on ROIC

Add Number of Employees ≥10 (to filter out Financials/Trusts)

Add Avg Trading Volume in Last month ≥10,000 (to filter out OTC)

Improved Magic Formula Investing with MSN Stock Screener

Here is a Link to the new Improved Magic Formula Investing screen

The MSN Magic Formula screen attempts to replicate Greenblatt's formula.

It does a very good job at highlighting companies with high ROIC and high EY (Low PE)

It cannot exactly match www.magicformulainvesting.com's results due to different parameters' definition

Note: MSN's results will also include some ADRs that you'll have to manually remove as it is not possible to exclude them from the screening.

In his Magic Formula Investing FAQ, Greenblatt says that his tweak to the ROIC and EY formulas is not the magic and any screen that reasonably captures the essence of the magic formula should have similar success.