In his 2005 bestseller “The Little Book That Beats the Market,” Joel Greenblatt (Trades, Portfolio) introduced the investing world to the Magic Formula, a simple mathematical formula to find profitable businesses that trade at bargain prices.
The formula ranks companies primarily based on two metrics: earnings yield and return on capital. Greenblatt defines the earnings yield as earnings before interest and taxes (Ebit) divided by enterprise value; this metric measures how much the company earns compared to how much the stock is valued by the market. The return on capital, meanwhile, is calculated as Ebit divided by the sum of net fixed assets and net working capital and measures how much a company earns compared to what it spends to produce those earnings.
One way that investors can search for stocks based on Greenblatt’s Magic Formula is through the GuruFocus Magic Formula Screener. Not only can this screener look for Magic Formula stocks, it can also organize the stocks based on criteria such as business predictability, dividend yield, price-earnings ratio and Ebitda growth.
Following the debut of ChatGPT at the end of 2022, investors have been hyped about artificial intelligence stocks. Thus, many companies with strong AI tailwinds have become overvalued relative to their ability to generate profits. According to the Magic Formula screener, three stocks that still look undervalued despite their ability to generate profits and their investments in AI are Arrow Electronics Inc. (ARW, Financial), Cognizant Technology Solutions Corp. (CTSH, Financial) and Skyworks Solutions Inc. (SWKS, Financial).
Arrow Electronics
Arrow Electronics (ARW, Financial) is an electronics company that specializes in a wide variety of electronic components, computer products and related value-added services. Its areas of specialty include enterprise computing, internet of things and digital transformation.
Arrow has formed a partnership with Qualcomm Inc. (QCOM, Financial) to accelerate the adoption of edge computing and artificial intelligence, which should help boost the sales of relevant components and services for both companies. The partnership has established the Edge Labs Center of Excellence, which will help customers develop application-specific solutions and provide relevant training for Qualcomm’s products and offer design services to enable lower risk and faster time to market through Arrow’s eInfochips subsidiary.
The company has a return on capital of 33.06%, which is better than 77% of other companies in the hardware industry, and an earnings yield of 19.34%, which outperforms 89% of industry peers.
On March 31, shares traded around $123.21 apiece for a market cap of $7.21 billion and a price-earnings ratio of 5.66. Over the past three years, the company’s revenue per share has grown an average of 17.9% per year, while its Ebitda per share has grown an average of 117.1% per year.
Cognizant Technology Solutions
Cognizant Technology Solutions (CTSH, Financial) is an information technology and services company which operates in four groups: financial services, health care, products and resources and communications, media and technology.
Cognizant has embraced artificial intelligence as a natural way to boost big data. The company is working on integrating what it calls evolutionary AI solutions into data platforms to help customers realize tangible data outcomes through instant decision-making and insights on vast amounts of information that humans simply would not have the time to work through.
The company’s return on capital is 83.35%, while its earnings yield is 10.3%, outperforming 73% and 84% of software industry peers, respectively.
The share price traded around $60.26 on Friday for a market cap of $30.92 billion and a price-earnings ratio of 13.63. The company’s three-year revenue per share growth rate is 7.7%, while its three-year Ebitda per share growth rate is 7.9%.
Skyworks Solutions
Skyworks Solutions (SWKS, Financial) is a semiconductor company based in Woburn, Massachusetts. It primarily manufactures semiconductor modules for radio frequency, memory and mobile communications systems.
As a semiconductor company, Skyworks is not directly involved with developing artificial intelligence solutions. However, AI needs a lot of silicon, so semiconductor companies are expected to enjoy a huge boost in demand due to the growing integration of AI in many aspects of technology. Skyworks expects to benefit directly from the growth in artificial intelligence through demand for more semiconductors, and indirectly as its customers in industries such as health care, industrial automation, emergency response and more leverage AI solutions to grow their business.
Skyworks’ return on capital is 43.35%, outperforming 73% of semiconductor industry peers. Meanwhile, its earnings yield is 7.19%, which is better than 64% of others in the industry.
On March 31, shares traded around $116.42 apiece for a market cap of $18.43 billion and a price-earnings ratio of 15.88. The company grown its revenue per share by 20.2% per year and its Ebitda per share by 21.1% per year on average over the past three years.
