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The "Magic Formula" works by choosing companies scored the best in two criteria:

  • How good business is, how efficiently it can reinvest its own money and grow Return on Capital = EBIT / (Net Working Capital + Net Fixed Assets).
  • How cheap we can buy it EBIT / Enterprise Value, EV calculated as a sum of Market Cap + all the debts.

So basically it looks - how fast business will be growing and how cheap we can buy it. Greenblatt says it removes the interest and taxes to remove distortions and compare companies working in different tax jurisdictions on the same ground.

What I don't understand why it ignores the taxes? For example we have two equal businesses in high-tax and low-tax countries. And the formula will score it as equals.

Although they are not, with all other things the same, business in low-tax country is preferable as it would generate more money after the taxes.

Alex Craft
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    With regards to taxes, the distortion is due to non-uniformity. For instance, the company might have a large write-off or tax bill one year. This could change what is a profitable year into a loss on paper. I'm not sure that is long enough to turn into an answer,though. –  Nov 27 '19 at 23:52
  • @Michael thanks, I see, makes sense. I initially had international markets in mind and was confused why he decided to ignore that. – Alex Craft Nov 28 '19 at 02:44

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