Magic formula investing is a rules-based approach to picking stocks created by Joel Greenblatt. He described this method in his 2005 book "The Little Book That Beats the Market." The system uses just two financial metrics to find companies that are both high quality and undervalued. Many investors follow it because the steps are simple, the logic is clear, and the historical results have been strong across multiple market cycles.
The core idea is to buy good companies at bargain prices. Most investors struggle with this. They chase expensive growth stocks when markets rise. Others buy cheap stocks without checking whether the low price reflects real problems.
The magic formula fixes this by ranking every stock on two numbers. One number shows business quality. The other shows how cheap the stock is relative to earnings. The result is a ranked list of companies that score well on both counts at the same time.
The power of the system lies in its consistency. No emotional judgment. No guessing about management quality. No relying on headlines.
The formula applies the same two tests to every company in the same way each time. This removes the bias that causes most investors to underperform the stock market over the long run.
How the Magic Formula Works
The magic formula ranks companies using return on invested capital and earnings yield. Return on invested capital measures how well a company turns its capital into profit. Earnings yield measures how cheap the stock is relative to what the business earns.
Combining these two rankings reveals which stocks are strong businesses at reasonable prices. This two-factor approach is what makes formula investing effective at finding winners over time.
The return on invested capital formula divides EBIT by net working capital plus net fixed assets. EBIT measures operating profit before interest and taxes. Net working capital equals current assets minus current liabilities. Net fixed assets are tangible long-term assets like property and equipment. This strips out the impact of tax rates and debt levels so investors can compare companies fairly across different sectors and structures.
To get earnings yield, divide EBIT by enterprise value. Enterprise value adds market capitalization and net debt of a company together. This shows how much pre-tax profit comes with each dollar spent on the business. A high earnings yield means the stock is cheap relative to its earnings power. The EBIT net approach gives a clearer view than standard price-to-earnings ratios because it removes noise from different debt levels and tax setups.
Step-by-Step Process for Formula Investing
Start by setting minimum requirements. Joel Greenblatt suggests filtering for companies worth at least 50 million dollars in market capitalization. This removes small stocks that lack trading liquidity and many volatile names. Some investors set the bar at 500 million to focus on more stable firms. Next, remove all financial companies and utilities. Banks borrow heavily, which makes the return on invested capital formula less useful. Utilities face regulation that limits what the return metrics can reveal. These exclusions keep the rankings focused on real business quality.
After filtering, calculate return on invested capital and earnings yield for every remaining company. Assign a rank from 1 to N on each metric. Add the two rankings together to get a combined score. Lower combined scores mean higher placement on the magic formula list. A stock that ranks 5th on return on invested capital and 12th on earnings yield has a combined score of 17. A stock ranking 30th and 2nd has a combined score of 32. The first stock ranks higher on the final list. This combined ranking balances quality and value equally.
Build the portfolio by buying the top 20 to 30 ranked stocks from the final list. Owning 20 to 30 names limits the damage from any single bad pick. Joel Greenblatt recommends adding five to seven new positions per quarter until the portfolio fills up. Hold each position for about twelve months to give the market time to reprice the shares. After a year, sell losers just before the twelve-month mark and winners just after it for tax efficiency. Then replace each sold position with new top-ranked names from the current list.
Why Magic Formula Investing Beats the Market
The historical data shows that magic formula investing beats the market over long periods. In his original research, Joel Greenblatt tested the strategy from 1988 to 2004. During that period, the magic formula produced annual returns of about 30 percent. The S&P 500 returned about 12 percent per year over the same stretch. This gap in annual returns caught the attention of both individual and professional investors. The formula worked across recessions and boom times alike.
The reason the formula delivers long term outperformance is that most investors are emotional. They sell good companies in short-term downturns and buy popular stocks at inflated prices. The magic formula ignores emotions. It finds the best combination of quality and value and repeats the process every year. Stock based returns eventually line up with true business value as the market corrects its pricing errors. The strategy delivers results precisely because the discipline it demands is too difficult for most investors to sustain through bad years.
Long term outperformance does not come every year. The magic formula can underperform the S&P 500 for stretches of one, two, or even three years. That is expected and even necessary. If the strategy beat the market in every single year, the edge would vanish. Every investor would use it and arbitrage the advantage away. The annual returns vary widely, but the compounding effect over a full market cycle is what matters most. Investors who follow the formula for five years or more tend to see the gap widen between their results and the broad stock market.
Return on Invested Capital Explained
Return on invested capital is one of the two pillars of the magic formula. It measures how much profit a company earns relative to the capital invested in its operations. A company earning 40 cents for every dollar of capital is clearly better than one earning 10 cents. High marks on this metric often point to a lasting competitive edge. This could be a strong brand, a patent, or a network effect that competitors find hard to replicate.
The formula uses EBIT rather than net income because EBIT net removes the effects of interest expenses and taxes. Two companies might have the same operating strength but different net incomes because one carries more debt or operates in a higher-tax region. By focusing on EBIT, the magic formula compares operational quality without these distortions. Using net working capital plus net fixed assets in the denominator captures only the capital truly at work inside the business, not idle cash or intangibles.
Companies with consistently high return on invested capital tend to have wide economic moats. These firms can raise prices without losing buyers or benefit from scale advantages smaller rivals cannot match. The magic formula identifies these quality businesses systematically without relying on subjective judgment about management or brand strength. When the return on invested capital formula is applied consistently across a large stock universe, the companies that rise to the top of the list are often the highest-quality businesses in the market.
Earnings Yield Explained
Earnings yield is the second pillar of the magic formula. It shows how much an investor pays for each dollar of earnings. A stock with a 10 percent earnings yield costs 10 dollars for every dollar of annual earnings. A 5 percent yield means the cost is 20 dollars for the same dollar of earnings. All else equal, investors want stocks with higher earnings yields. They get more earnings for each dollar invested. Earnings yield makes cheap stocks easy to compare across all market capitalizations.
The magic formula calculates earnings yield as EBIT divided by enterprise value. Enterprise value equals market capitalization plus debt minus cash. Two stocks might look equally cheap on a price-to-earnings basis, but the one with less debt will show a higher earnings yield under this calculation. Joel Greenblatt chose these specific definitions because they produce cleaner comparisons across different tax structures and debt levels. Standard metrics like return on equity and price-to-earnings are distorted by leverage and accounting choices. The magic formula removes those distortions.
Common Mistakes with the Magic Formula
The biggest mistake is abandoning the strategy too soon. The magic formula will underperform the S&P 500 in some years. Many investors lose faith during these stretches and switch to a different approach. The periods of underperformance are what create the opportunity for long term outperformance. If the strategy beat the market every single year, everyone would use it and the edge would disappear from the stock market entirely.
Another common error is cherry-picking from the ranked stocks list. Some investors look at the top names and skip companies they do not like based on recent news or unfamiliar industries. This removes the systematic advantage. The magic formula works as a portfolio of 20 to 30 positions, not as a hand-picked list of favorites. A third error is using incorrect inputs. Always use EBIT and enterprise value as specified. Substituting net income for EBIT or market capitalization for enterprise value produces different rankings that do not carry the same historical performance. Use the exact definitions Joel Greenblatt described in his original work.
Who Should Use Magic Formula Investing
Magic formula investing suits investors who want a systematic, evidence-based approach without spending hours reading financial statements. The steps are simple once understood: screen for ranked stocks, buy the top names, hold for a year, and repeat. This simplicity makes the method accessible to anyone with limited time for investment research. The formula does the analytical work automatically.
The strategy also works well for investors who recognize their own emotional tendencies. If panic selling or chasing trends has hurt your returns, the magic formula provides a rigid framework that overrides those impulses. The rules leave no room for emotional decision-making. Discipline is often the difference between average and excellent long-term results in the stock market.
Find Magic Formula Stocks with ValueMarkers
The magic formula works best when applied to a large universe of stocks. ValueMarkers covers stocks across 73 global exchanges, giving you the widest possible pool to screen for formula investing candidates. Use the Quality pillar to find companies with high return on invested capital. Use the Value pillar to find stocks with strong earnings yield relative to their peers. This two-factor approach mirrors the exact logic of the magic formula strategy.
The ValueMarkers Screener lets you filter by ROIC, earnings yield, debt levels, and financial health scores in one place. Screen across all sectors and market capitalizations to find the top-ranked stocks. Buy the best combination of quality and value, hold through the full market cycle, and let the strategy work. The magic formula rewards patience and consistency above all else.
Diversify across sectors when building your portfolio from the formula investing results. The screener makes it easy to check whether your selections are spread across industries or clustered in one area. A well-spread list of 20 to 30 cheap stocks with strong return on invested capital gives you the best chance of capturing the long term outperformance the magic formula has delivered across multiple market cycles.