As we already know, the magic formula picks stocks that have both a high earnings yield and a high return on capital. For earnings yield, the formula looks for companies that earn a lot compared to the price we have to pay. For return on capital, the formula looks for companies that earn a lot compared to how much the company has to pay to buy the assets that created those earnings. To calculate these ratios, the magic formula doesn’t look at future earnings. That’s too hard. The magic formula uses last year’s earnings.
