Joel Greenblatt (Trades, Portfolio) introduced the individual investing world to the “Magic Formula” when he published his 2005 book, “The Little Book That Beats the Market.” The idea behind the Magic Formula is to apply a simple mathematical formula to find profitable businesses that trade at bargain prices.
The formula ranks companies based on the combination of two metrics: earnings yield and return on capital. The earnings yield, which is defined as earnings before interest and taxes (Ebit) divided by enterprise value, measures how much the company earns compared to how much the stock is valued by the market. The return on capital, which is defined as Ebit divided by the sum of net fixed assets and net working capital, measures how much a company earns compared to what it spends to produce those earnings.
As the formula works best when applied to U.S. companies and companies with market caps of at least $100 million, I have eliminated companies that do not meet these criteria from my search. Small-cap and non-U.S. businesses are often structured differently, so being ranked highly by the “Magic Formula” would not indicate that they are good investments. For the same reason, utilities and financial companies are also not considered.
Below are three potentially undervalued companies that are financially strong, have a GuruFocus business predictability rating of 3 or more and rank highly on the GuruFucus Magic Formula Screener, a Premium feature based on Greenblatt’s formula.
Grupo Aeroportuario del Pacifico
One company that ranked highly on the Magic Formula Screener was Grupo Aeroportuario del Pacifico SAB de CV (PAC, Financial). Commonly known as GAP, the Guadalajara-based holding company operates airports in the Pacific and central regions of Mexico.
The company has an earnings yield of 10.12%, a return on capital of 429.73% and a business predictability rating of three out of five stars.
On June 8, shares of GAP traded around $79.60 for a market cap of $4.48 billion and a price-earnings ratio of 16.41, which is lower than the 10-year median price-earnings ratio of 23.54. GuruFocus gives the company a financial strength rating of 7 out of 10 and a profitability rating of 8 out of 10. According to the Peter Lynch chart, the stock trades near its intrinsic value.
GAP has a cash-debt ratio of 1.12 as of the end of 2019, which is higher than the industry median of 0.25. The Altman Z-Score of 4 and current ratio of 5.27 also show that the company has plenty of liquidity and is safe from bankruptcy.
With an operating margin of 47.27%, GAP has grown its revenue at a rate of 13.5% per year and its Ebitda at a rate of 17.6% per year over the past three years, though the quarter ended March 31 showed an expected decline as travel slowed in response to the pandemic.
Korn Ferry
Another company that ranked highly on the Magic Formula Screener was Korn Ferry (KFY, Financial). The Los Angeles-based management consulting company operates in 52 countries around the world, helping clients to organize their management structures and matching them with their ideal job candidates.
The company has an earnings yield of 12.36%, a return on capital of 70.49% and a business predictability rating of 3.5 out of 5 stars.
On June 8, shares of Korn Ferry traded around $33.67 for a market cap of $1.85 billion and a price-earnings ratio of 12.12, which is lower than the 10-year median price-earnings ratio of 20.3. GuruFocus gives the company a financial strength rating of 6 out of 10 and a profitability rating of 8 out of 10. According to the Peter Lynch chart, the stock is trading below its intrinsic value.
The cash-debt ratio of 0.94 is higher than the industry median of 0.67, while the Altman Z-Score of 2.46 and the current ratio of 2.14 indicate that the company’s financial situation is stable.
The operating margin of 11.53% is higher than 73.45% of other companies in the business services industry. Korn Ferry has grown its revenue at a rate of 11.4% per year and its Ebitda at a rate of 13.2% per year over the past three years.
Steelcase
Steelcase Inc. (SCS, Financial) also ranked highly on the Magic Formula Screener. Headquartered in Grand Rapids, Michigan, the company is the largest manufacturer of office furniture in the world. It also produces architectural and technology products for offices as well as education, health care and retail facilities.
The company has an earnings yield of 15.25%, a return on capital of 36.84% and a business predictability rating of 3.5 out of 5 stars.
On June 8, shares of Steelcase traded around $13.90 for a market cap of $1.6 billion and a price-earnings ratio of 8.41, which is lower than the 10-year median price-earnings ratio of 19.34. GuruFocus gives the company a financial strength rating of 6 out of 10 and a profitability ranking of 8 out of 10. According to the Peter Lynch chart, the stock is trading below its intrinsic value.
The cash-debt ratio of 0.73 is lower than the industry median of 0.9, but the Altman Z-Score of 3.16 and current ratio of 1.72 indicate that the company is able to meet its financial obligations.
The operating margin of 6.37% is higher than 54.1% of competitors in the industrial products industry and compares favorably to the company’s historical median of 5.35%. Over the past three years, revenue has grown at a rate of 7.4% per year, while Ebitda has grown at a rate of 9.7% per year.
Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.
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