What if you could compress all of value investing into two numbers and a ranking? That is essentially what Joel Greenblatt’s Magic Formula attempts: buy good companies at cheap prices, decided mechanically, emotion removed. It is elegant, its logic is sound — and its real difficulty is nothing to do with the maths.
Two rankings, added together
The formula ranks every stock twice. Once by return on capital — a quality measure, close in spirit to ROIC — from best to worst. Once by earnings yield — operating profit against enterprise value, a cheapness measure — from highest to lowest. Add each stock’s two ranks, and the lowest combined scores are the companies that are both good and cheap. You buy a diversified basket of the top names, hold for a year, then re-rank and rebalance.
- How well the business uses its capital
- High = a genuinely good business
- Kin to ROIC
- Filters out weak companies
- Operating profit ÷ enterprise value
- High = paying little for the profit
- A price discipline
- Filters out overpriced ones
The Magic Formula ranks stocks on return on capital and earnings yield combined. What is the single biggest reason most investors fail to capture its returns?
Greenblatt ka Magic Formula: har stock ko do cheezon pe rank karo — return on capital (quality) aur earnings yield (sasta) — dono rank jodo, sabse achhe combined score khareedo. Saal bhar rakho, phir rebalance. Logic solid hai. Par asli mushkil formula nahi — use tik ke rakhna hai; ye saalon underperform karta hai aur log galat waqt pe chhod dete hain. Financials hata do, aur F-score/M-score se value trap aur milaawat chaanto.
- The Magic Formula ranks stocks on return on capital (quality) and earnings yield (cheapness).
- The two ranks are added, and the best combined scores form a diversified basket held ~a year.
- Its logic — buy good businesses cheap — is sound and backtests well long term.
- The hard part is behavioural: holding through long stretches of underperformance.
- Screen out financials, and check the output for value traps and manipulated books.
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Common questions
Short, direct answers to what people ask about this topic.
- what is greenblatt’s magic formula
- The Magic Formula is a systematic stock-picking method created by investor Joel Greenblatt that ranks companies on two measures at once: return on capital, which captures business quality, and earnings yield, which captures cheapness. Each stock gets a rank on each measure, the ranks are added, and the lowest combined ranks — good businesses trading at cheap prices — form the portfolio. The idea, laid out in his book, is to mechanically buy above-average companies at below-average prices and hold a diversified basket of them, rebalanced yearly.
- how does the magic formula work
- You rank every stock in your universe by return on capital from best to worst, then rank them separately by earnings yield from highest to lowest. Adding each stock’s two ranks gives a combined score, and you buy a basket of the top-scoring names — those that rank well on both quality and cheapness together. The portfolio is typically held for a year and then re-ranked and rebalanced. It is deliberately mechanical, designed to remove emotion and force the investor to buy unglamorous, cheap, quality companies the market is ignoring.
- does the magic formula actually work
- Greenblatt’s own backtests showed the Magic Formula beating the market handsomely over long periods, and the underlying logic — buying quality cheaply — is sound. But it works only across a diversified basket held with discipline over many years, and it endures stretches of underperformance that cause most people to abandon it at the worst time. The edge, if it exists, comes partly from that difficulty: the strategy is unpleasant to hold precisely when it is working hardest, so the behavioural discipline to stick with it is the real barrier, not the formula.
- what are the limitations of the magic formula
- The formula can be tripped up by companies whose numbers are distorted — one-off gains, cyclical peaks that flatter earnings yield, financial firms and utilities where the ratios mean something different, and outright accounting manipulation that a mechanical screen cannot see. It also says nothing about the future, so it can load up on businesses in structural decline that merely look cheap and profitable today. It is best treated as a disciplined starting screen whose output still deserves a check for value traps and cooked books, not a hands-off autopilot.