The Magic Formula Screener: Greenblatt Explained

In 2005, Joel Greenblatt published "The Little Book That Beats the Market," introducing the Magic Formula — and we've found that its core insight (buy quality at a discount) aligns with our own approach. It's a deceptively simple stock screening method that ranks all stocks by two criteria: earnings yield (how cheap it is) and return on capital (how good the business is). Buy the top-ranked stocks, hold for a year, and repeat.

Greenblatt's backtests showed the Magic Formula outperforming the S&P 500 by a wide margin over 17 years. The idea is elegant: systematically buy good businesses at cheap prices, and the combination of quality and value does the heavy lifting.

How the Magic Formula Works

The formula ranks all stocks on two metrics independently, then combines the rankings. Earnings yield = EBIT / Enterprise Value. This measures how much pre-tax, pre-interest operating profit you're buying per dollar of enterprise value. Higher is cheaper. Return on capital = EBIT / (Net Fixed Assets + Working Capital). This measures how efficiently the business uses its tangible capital to generate operating profit. Higher is better.

Every stock gets a rank on each metric (1 = best). The combined rank (earnings yield rank + return on capital rank) determines the final order. The top 20–30 stocks get bought. You hold for a year, sell, and rebuild the portfolio with the new top-ranked stocks.

Strengths of the Approach

The Magic Formula's genius is combining quality and value in a single, mechanical system. Most value screens look only at price (low P/E, low P/B). Most quality screens look only at business metrics (high ROIC, strong margins). The Magic Formula insists on both — it won't buy a cheap stock unless the business is also high-quality, and it won't buy a quality stock unless the price is also attractive.

The mechanical nature removes emotion. You don't have to decide whether a stock "feels" cheap or whether a business is "good enough." The formula decides. This discipline prevents the behavioral mistakes that undermine most investors' returns.

Limitations

The Magic Formula doesn't assess moat durability. A company can have high current return on capital from a temporary competitive advantage that's about to erode — the formula treats it the same as a company with a decades-old moat. It also uses single-year financial data, which can be misleading for cyclical businesses at peak earnings.

Real-world implementation is harder than the backtest suggests. The formula produces many small-cap and unfamiliar names that investors find psychologically difficult to hold. Annual turnover creates tax inefficiency. And during multi-year underperformance periods — which are inevitable — most investors abandon the system before it recovers.

How to Screen for the Magic Formula

Greenblatt runs a free screener at magicformulainvesting.com that outputs the top-ranked stocks. Gurufocus offers a dedicated Magic Formula screen. You can approximate it on Finviz by sorting for a combination of low EV/EBIT (earnings yield proxy) and high ROI (return on capital proxy).

For a more robust version, add moat analysis and multi-year financial data to Greenblatt's framework. The Magic Formula's weakness — single-year data and no moat assessment — is exactly what quality scoring systems address by evaluating business durability across multiple dimensions and time periods.