The principles of magic formula investing was laid out in Joel Greenblatt’s The Little Book That Beats The Market. For years, I have wrote on my findings and experiences but I feel its a bit unfair for those who are new to investing and the world of finance. And while the little book might have been written for beginners, it leaves a lot of questions unanswered. For example, how do you calculate the magic formula numbers without losing your mind? Where do you find these numbers? Does it matter whether Earnings Yield is 10.59% or 11%?

How does the book calculate Earnings Yield?

At its core, and this is a bit too basic, the book calculates Earnings Yield by inverting the P/E ration. For example, if a stock currently has a P/E ratio of 10, it would have an earnings yield of 10%. We arrive at this by divide 1/10.

Did you look in the Appendix Section of the Little Book That Beats The Market?

The appendix section of the book starts on page 137 in which Joel Greenblatt recommends some very important updates to the magic formula. The changes he recommends include the changes as to how to calculate Earnings Yield and Return on Capital. He has several reasons for this in which I will go over in another article so let’s go through a step by step guide on how to calculate earnings yield using readily available resources.

Earnings Yield= EBIT/ Enterprise Value

EBIT= Pre- tax operating earnings a.k.a. operating earnings or income

Enterprise Value= Market Cap+ Preferred Equity+ Net Interest-Bearing Debt- Total Cash and Equivalents

For enterprise value, many get confused with interest bearing debt, but in its most simplest form you can look at it as long term debt.

For our example, we will be looking at magic formula stock Lorillard Inc (LO) which has been on the magic formula screen for quite some time.

To find EBIT, we must look at the company’s income for the trailing twelve months (ttm). This is located on the income statement and can be found by visiting any source that will provide the information such as Google Finance, Yahoo Finance or Morningstar.com For this example, we will use Morningstar.

To find operating income we want to go to Quote—-> Financials—–>10 Yr Income

Now we are looking on the far right for “Operating Income”

EBIT=1.629 Billion

This will be the basis for calculating Earnings Yield and ROIC. Next we have to find Enterprise Value. To do this, we go back to “Quote” and write down market cap.

Market Cap= 11.2 Billion

Next we go back to Financials—–>10-Yr Balance Sheet

First, we take a look if the company has any preferred stock outstanding. Morningstar doesn’t show this data but Google Finance does. In most cases, companies will not have preferred shares outstanding, but we want to make sure. Next, we take note of any long term debt the company has, if any. In this case, 735 million. Finally, we look to see if the company has cash on hand. Lorillard does and we also take note and write down 1.659 billion.

Now we simply put our numbers together.

EBIT= 1.629

Enterprise Value= Market Cap (11.2)+Long Term Debt (.735)- Cash & Equivalents (1.659)= 10.276

Now divide and you arrive at Earnings Yield

1.629/10.276= 15.85%

Definitely not bad. At this point, I would look then move on to how to calculate Return On Invested Capital. If the earnings yield is lower than 10%, I simply stop my analysis at this point and move on to another stock.