Joel Greenblatt's Magic Formula Explained

Joel Greenblatt’s magic formula ranks stocks on two measures — earnings yield and return on capital — then buys a basket of those that score best on both. The idea, set out in The Little Book That Beats the Market, is to systematically buy good businesses at cheap prices, using a simple, rules-based method.

Where this fits: the magic formula is a mechanical way to combine Criterion 1 (a great business) and Criterion 5 (a reasonable price) of the Five Criteria. This article is part of our Learning from the Masters series.

Who Is Joel Greenblatt?

Joel Greenblatt is an American investor, hedge fund manager and teacher. He founded Gotham Capital and has taught at Columbia Business School, the spiritual home of value investing since Benjamin Graham lectured there.

He is the author of two well-known books. You Can Be a Stock Market Genius (1997) covers special situations such as spin-offs and restructurings. The Little Book That Beats the Market (2005) introduced the magic formula to a wide audience and is deliberately written to be understood by non-professionals.

Greenblatt also co-founded the Value Investors Club, an online forum for sharing detailed investment ideas. His standing as both a practitioner and a teacher is why his formula is taken seriously rather than dismissed as a gimmick.

The Idea Behind the Formula

The magic formula tries to do, mechanically, what good value investors do by judgement: buy a good business at a cheap price.

Greenblatt argued that two simple questions capture most of what matters:

1. Is the business a good one? Good businesses earn high returns on the capital they use.
2. Is the price cheap? A stock is cheap when it earns a lot relative to what you pay for the whole enterprise.

A company that scores well on both — a genuinely good business trading at a bargain price — is exactly what every value investor wants. The formula’s contribution is to measure both in a consistent way and let the ranking, rather than emotion, drive the decision.

The Two Ingredients

The whole method rests on two ratios. Greenblatt chose specific definitions to make them comparable across companies with different debt levels and tax rates.

Earnings yield

Earnings yield measures how cheap a stock is. Greenblatt defines it as operating earnings (EBIT, or earnings before interest and tax) divided by enterprise value.

• EBIT is the profit the business generates from operations, before the effects of how it is financed or taxed.
• Enterprise value is the market value of the equity plus net debt — in effect, what it would cost to buy the whole business.

Using EBIT over enterprise value, rather than the more familiar P/E ratio, lets you compare companies on a like-for-like basis regardless of how much they borrow. A higher earnings yield means a cheaper business.

Return on capital

Return on capital measures how good the business is. Greenblatt defines it as EBIT divided by tangible capital employed — broadly, net working capital plus net fixed assets.

The logic is the same as our own emphasis on return on invested capital: a company that earns a high return on the capital it actually uses is creating real value. A higher return on capital means a better business.

How the Ranking Works

The clever part is how Greenblatt combines the two measures. He does not set fixed thresholds. Instead he ranks every company against all the others on each factor, then adds the ranks together.

The steps, in plain terms:

1. Start with a large universe of stocks, excluding very small companies, financials and utilities.
2. Rank every company by earnings yield, cheapest first (rank 1, 2, 3 and so on).
3. Rank every company by return on capital, best first (rank 1, 2, 3 and so on).
4. Add each company’s two ranks together.
5. Buy a basket of the companies with the lowest combined score.

A company need not be the very cheapest or the very best. The winner is the one that scores well on both at once — a strong combined rank.

A simplified illustration

The table below shows how the combined ranking works, using a handful of hypothetical companies and made-up ranks.

Company	Earnings yield rank	Return on capital rank	Combined score
A	5	8	13
B	2	40	42
C	25	3	28
D	60	70	130

Company A wins, not because it tops either list, but because it scores well on both. Company B is very cheap but a poor business; Company C is an excellent business but not cheap enough. Company D is neither. This example is hypothetical and the ranks are illustrative only.

How It Is Meant to Be Used

Greenblatt designed the formula to be followed mechanically, which is central to why it can work.

• Buy a basket, not one stock. The results rely on averages across twenty or thirty holdings, so that the winners outweigh the inevitable losers.
• Rebalance periodically. The approach typically involves holding for around a year, then re-running the ranking and refreshing the basket, with tax rules handled sensibly.
• Follow it consistently. The method only works if you keep applying it through good years and bad, rather than overriding it when it underperforms.

The discipline is the whole point. By removing judgement from each individual decision, the formula protects the investor from the emotional mistakes that wreck most strategies.

Why It Can Work, and Why People Abandon It

Greenblatt presented back-tested results suggesting the formula outperformed the market over long periods. Whatever the precise figures, the underlying logic is sound: buying good businesses cheaply, systematically, is a time-tested idea.

The catch is temperament. Greenblatt himself has stressed that the formula can underperform the market for years at a stretch. A method that lags for two or three years feels broken, and most investors give up precisely when they should hold on.

This is the recurring theme across the masters: the edge is as much behavioural as analytical. A strategy only works if you can actually stick with it, which is why we keep returning to why most beginners fail at investing.

Where the Formula Needs Care

The magic formula is a fine teaching tool and a reasonable starting screen, but it has real limits.

• It is backward-looking. It ranks on recent earnings and capital, which may not reflect a business whose fortunes are changing.
• It can flag value traps. A high earnings yield sometimes signals a declining business, not a bargain. The formula cannot tell the difference.
• It ignores debt quality and durability. It says nothing directly about the balance sheet risk or whether a moat is durable.
• It needs breadth and patience. Running it on three stocks instead of thirty, or abandoning it after a bad year, defeats the design.

For these reasons we treat the formula as a way to generate candidates, not a final decision. A high-ranking company still deserves a proper look at its moat, management and balance sheet before you commit.

How the Magic Formula Fits the Five Criteria

The formula is essentially a mechanical first pass over two of our five Criteria. It is strong on quality and price and silent on the rest, which is exactly how we use it.

Formula element	Five Criteria link	What it covers
Return on capital	1. Great business	High returns on capital employed
(not covered)	2. Durable moat	Nothing on whether returns can last
(not covered)	3. Aligned management	Nothing on capital allocation or ownership
(not covered)	4. Sound balance sheet	Nothing on debt safety
Earnings yield	5. Reasonable price	Cheapness relative to enterprise value

Read this way, the formula is a superb idea generator and a weak final filter. It finds cheap, good-looking businesses fast; the Five Criteria then check whether the quality is durable and the finances are safe.

Frequently Asked Questions

Is the magic formula really “magic”?

No, and Greenblatt chose the name partly with a smile. It is a disciplined, rules-based way to buy good businesses cheaply. The results come from consistency and sound logic, not from anything mysterious.

Why does it use EBIT and enterprise value instead of the P/E ratio?

Because EBIT over enterprise value compares companies fairly regardless of how much debt they carry or what tax they pay. The ordinary P/E ratio can be distorted by financing and tax differences, making cross-company comparisons less reliable.

How many stocks should a magic formula portfolio hold?

Greenblatt’s approach relies on a diversified basket, typically twenty to thirty names, so that strong performers outweigh the duds. Running it on a tiny number of stocks removes the averaging that makes it work.

Should I use the magic formula on its own?

We would not. It is an excellent screen for finding candidates, but it ignores moats, management and the balance sheet, and it can flag value traps. Treat its output as a research list, then apply a fuller framework. See also when is a stock cheap.

Your Next Step

The magic formula shows how far two good numbers can take you when applied with discipline. Turn its candidates into decisions with the Five Criteria framework, understand the quality side with return on invested capital, and compare Greenblatt’s rules-based method with the judgement-led approaches in lessons from the greatest investors of all time. To score a specific company, use the Five Criteria scorecard.

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About the author: Cameron Hayes is a senior investor relations and finance professional who has worked in IR at Nasdaq Copenhagen-listed companies including Nilfisk and Maersk Drilling. He holds an MSc from Copenhagen Business School and a BCom from the University of Ottawa, and founded Gingernomics to teach individual investors the Five Criteria framework. More about Gingernomics.

The content on Gingernomics is for educational and informational purposes only and does not constitute financial advice. Always do your own research and consult a licensed financial advisor before making any investment decisions. Past performance is not indicative of future results.