In 2005, hedge fund manager Joel Greenblatt published "The Little Book That Beats the Market," presenting a deceptively simple investment strategy he called the Magic Formula. The concept: rank all stocks by two metrics — earnings yield and return on invested capital (ROIC) — add the two ranks together, buy the top-ranked stocks, hold them for a year, and repeat. Despite its simplicity, the strategy produced compelling backtested results and introduced an entire generation of investors to systematic, factor-based value investing.
The Two Pillars: Earnings Yield and ROIC
The Magic Formula's elegance lies in what it is actually measuring. Greenblatt designed it to answer two fundamental questions simultaneously:
- Are you buying a cheap business? (Earnings Yield)
- Are you buying a good business? (Return on Invested Capital)
Traditional value investing often focuses only on cheapness — buying low P/E or low P/Book stocks. The insight embedded in the Magic Formula is that cheap bad businesses tend to stay cheap or get cheaper, while cheap good businesses are more likely to mean-revert to higher valuations.
Earnings Yield
Greenblatt defines earnings yield as EBIT (earnings before interest and taxes) divided by enterprise value (EV). This is the inverse of the EV/EBIT multiple.
Earnings Yield = EBIT / Enterprise Value
Using EBIT rather than net income removes the distorting effects of different tax rates and financing decisions. Using enterprise value (market cap + debt − cash) rather than just market cap ensures that a heavily indebted company trading at a low market cap does not look artificially cheap. A company with $1B in market cap and $2B in debt has a $3B EV; a company with $1B in market cap and zero debt has a $1B EV. The same EBIT produces very different earnings yields — correctly, since the levered company has less residual value for equity holders.
Return on Invested Capital
Greenblatt defines ROIC as EBIT divided by net working capital plus net fixed assets. This measures how efficiently the business converts its operating capital into operating earnings.
ROIC = EBIT / (Net Working Capital + Net Fixed Assets)
Using EBIT in the numerator makes the metric pre-financing and pre-tax, allowing consistent comparison across companies with different capital structures and tax situations. The denominator — net working capital plus net fixed assets — captures the actual operating capital the business needs to function, stripping out excess cash and non-operating assets.
A high ROIC indicates that the business generates substantial operating earnings from a modest capital base — the hallmark of a company with pricing power, competitive advantages, or superior asset utilization.
The Ranking and Portfolio Construction Process
The practical implementation follows these steps:
- Start with a universe of US-listed stocks with market capitalizations above a minimum threshold (Greenblatt originally used $50M; many practitioners use $100M to $500M to reduce liquidity risk).
- Exclude financial companies (banks, insurance) and utilities, whose accounting makes ROIC and earnings yield comparisons meaningless.
- Calculate earnings yield (EBIT/EV) for every company. Rank from highest to lowest — the cheapest company gets rank 1.
- Calculate ROIC for every company. Rank from highest to lowest — the company with the highest return on capital gets rank 1.
- Add the two ranks for each company. The company with the lowest combined rank (e.g., ranked #5 on earnings yield and #10 on ROIC gives a combined rank of 15) represents the best combination of cheapness and quality.
- Buy the top 20-30 ranked stocks, spread entries over the year to reduce timing risk, hold each position for one year, then sell and rebalance.
Backtested Results and Academic Analysis
Greenblatt's original backtest (1988-2004 on US stocks with market caps above $50M) showed annualized returns of approximately 30.8% versus the S&P 500's 12.4% over the same period. This is an extraordinary claimed outperformance.
More conservative subsequent analyses using out-of-sample data have found more modest but still meaningful excess returns. Research published by academics including the AQR Capital team and others examining similar earnings yield + quality factor combinations found consistent positive excess returns over long periods, though with significant short-term volatility and multi-year periods of underperformance relative to the broad market.
The strategy's best periods have historically been following market downturns, when cheap high-quality stocks are most plentiful. Its most difficult periods have been during extended growth-stock bull markets (notably 2017-2020) when high-quality businesses commanded steep premiums and earnings yields on the best businesses were compressed.
Real-World Example: Identifying Candidates
Consider how the Magic Formula framework applies to a company like Booking Holdings (BKNG) in a hypothetical year where travel demand has rebounded but the stock has lagged the broader market.
If Booking generates, say, $3B in EBIT on an enterprise value of $20B, the earnings yield is 15% — a strong cheapness signal. If it generates that $3B in EBIT on relatively modest net working capital and asset requirements (a characteristic of asset-light businesses), the ROIC might be 25-40%. A company with both high earnings yield and high ROIC would rank highly in both dimensions, placing it near the top of the Magic Formula screen.
Contrast this with a capital-intensive industrial company generating the same 15% earnings yield but earning only 8% ROIC — its capital requirements are so large that the seemingly cheap price is offset by mediocre business economics.
Practical Implementation Considerations
Tax lot management matters. Greenblatt explicitly addresses this: sell losers just before the one-year mark (to take short-term capital losses) and sell winners just after (to qualify for long-term capital gains rates). Over a multi-year period, this timing discipline can materially improve after-tax returns.
Patience is required. The strategy systematically underperforms in roughly 25-33% of rolling one-year periods. Investors who abandon the strategy during underperformance periods forfeit most of the long-run benefit. Greenblatt noted that the strategy's effectiveness depends on most investors being unwilling to endure the emotional difficulty of holding underperforming stocks.
The universe matters. Applying the strategy only to large-cap stocks reduces the expected excess return but improves liquidity and reduces execution costs. The strongest documented excess returns come from mid-cap and small-cap applications, where market efficiency is lower.
Avoid financial companies and utilities. These sectors require fundamentally different analytical frameworks; including them produces misleading ROIC and earnings yield signals.
Limitations and Criticisms
The strategy can underperform for years. The most well-documented criticism is that patience requirements exceed most investors' capacity. The strategy would have significantly underperformed during extended periods such as 2007-2008 (value traps in cyclical industries) and 2018-2020.
EBIT as the earnings measure has flaws. Companies with heavy stock-based compensation or frequent large non-cash charges may appear cheaper on EBIT/EV than their economic reality warrants.
Sector concentration risk. In any given year, the top-ranked companies may cluster in specific sectors experiencing cyclical cheapness. An undiversified implementation amplifies sector-specific risks.
It ignores qualitative factors. Management quality, competitive dynamics, industry structure, and balance sheet leverage beyond what EV captures are all relevant to investment outcomes but are invisible in a purely quantitative screen.
Using the Magic Formula Calculator at ValueMarkers
The Magic Formula Calculator at ValueMarkers computes earnings yield (EBIT/EV) and ROIC for any ticker using trailing financial data. Investors can use this tool to evaluate individual candidates or to apply Magic Formula ranking logic to a watchlist.
The ROIC Calculator and Earnings Yield Calculator provide deeper breakdowns of each component, which is particularly useful when investigating why a specific company ranks highly or poorly on one dimension versus the other.
Key Takeaways
The Magic Formula is a systematic strategy that ranks stocks simultaneously on cheapness (earnings yield) and quality (ROIC), combining the best insights of value and quality investing. Backtested results are compelling, and factor research broadly supports the long-run efficacy of combined value-quality screens. The strategy's primary challenge is behavioral: it requires sustained patience through multi-year periods of underperformance that deter most investors from following through. Used as a starting point for identifying companies where both business quality and valuation are favorable, the Magic Formula framework represents a disciplined, evidence-based approach to stock selection.