The idea in one minute
Buy good businesses, but only when they're cheap. That is the whole idea, and almost every great investor would agree with it. Greenblatt's contribution was to turn it into two numbers and a ranking anyone can follow.
A good business earns a lot on the money tied up in running it. A bargain earns a lot compared with what it would cost to buy the whole company. Rank every company on both, add the two ranks together, and the companies with the best combined rank are the Magic Formula stocks.
The companies it picks are often out of favour, and owning them can feel uncomfortable. Greenblatt argues that this discomfort is exactly why the approach keeps working: most people can't stick with it.
Where it comes from
Joel Greenblatt founded the investment firm Gotham Capital and has taught value investing at Columbia Business School for many years. He set out the Magic Formula in The Little Book That Beats the Market (2005), written so that his children could understand it, and updated it in The Little Book That Still Beats the Market (2010).
Despite the name, the official Magic Formula website itself stresses that there is nothing magical about it and no guarantee of results.
The two measures
| Measure | Greenblatt's definition | What it tells you |
|---|---|---|
| Return on capital | Operating profit (EBIT) ÷ (net working capital + net fixed assets) | How much the business earns on the tangible capital it needs. Goodwill is deliberately left out. |
| Earnings yield | Operating profit (EBIT) ÷ enterprise value | How much the business earns compared with the price of the whole company, debt included. |
Why not just P/E and ROE? Both of Greenblatt's measures use operating profit and include debt. A company loaded with debt can look cheap on P/E and brilliant on return on equity; on enterprise value and tangible capital, the debt is counted. Swapping in the familiar ratios quietly turns it into a different strategy.
How the original method works
- Rank, don't filter. There are no fixed thresholds. Every company gets a rank on each measure, the two ranks are added, and the lowest totals win.
- Leave out banks, insurers and utilities, whose finances don't fit the two measures.
- Set a minimum size. Greenblatt used $50 million and suggested going higher for steadier results; his back-test used the 3,500 largest US companies.
- Build the portfolio gradually, a few top-ranked companies every couple of months, until it holds 20 to 30.
- Hold each for about a year, then replace it with a fresh top-ranked company.
- Give it three to five years. The formula can trail the market for two or three years at a time.
What the evidence shows
Greenblatt's own back-test is spectacular, but it is his own. The independent picture is more modest, and worth knowing:
- United States. Wesley Gray of Alpha Architect re-tested it and found that it works, but is less magic than the book suggests: simpler value measures did about as well.
- Benelux. About 7.7 percentage points a year above the market, according to Quant Investing's back-tests.
- Finland. Beat the market in the same body of tests.
- Oslo, 2003–2022. A master's thesis at the Norwegian School of Economics found about 8 points a year more than the market, but not clearly significant after trading costs.
- Europe-wide. Some tests found the pure formula struggled in parts of the 2000s, and did better when combined with a filter that avoids stocks that are still falling.
The honest summary: a sound, well-tested idea that has worked in many markets, with long dry spells, and with stronger results when it isn't used blindly.
Common mistakes
- Using P/E and ROE instead of EBIT/EV and return on tangible capital. It changes which companies come out on top.
- Including banks, insurers and utilities.
- Trusting one spectacular year. The formula uses a single year's operating profit. A one-off gain can put a company at the top of the ranking. Greenblatt himself warns about unusually low ratios.
- Giving up after a bad year. The long-run results depend on staying with it.
- Trading too often. The method is built around holding for about a year.
How ValuJack applies it
Ranked by the Magic Formula. QUEEN starts from our data provider's Magic Formula rank, which combines return on capital and earnings yield. Only companies near the top of the ranking for the whole market qualify. The provider doesn't publish its exact formula, so we treat the rank as a close version of Greenblatt's, not an exact copy.
Banks, insurers and utilities excluded. As Greenblatt specifies.
One company at a time, not a portfolio of 30. A card shows one company. Greenblatt's diversification and yearly rhythm are yours to apply; the card is a candidate, not a portfolio.
Steady earnings over five years. The formula looks at only one year of profit, so we also require a steady five-year record. This guards against the one-off spikes Greenblatt warns about.
Modest debt. A good business rarely needs heavy borrowing, so we cap debt relative to equity.
A share price that has stopped falling. The European evidence suggests the formula works better when stocks still in free fall are avoided. We want the price clearly above its one-year low.
The same final steps for every card
Whatever the strategy, a company only becomes a card after three more steps. Our own model estimates a fair value from the company's reported earnings, and only companies priced below it (or, for the two momentum and growth cards, not far above it) can be dealt. The Edge Check, described below, then reads the latest reports, filings and news for what the numbers can't show. Finally the company must be tradable at major European online brokers. The full process is on the methodology page, and every card ever dealt stays on the card history.
The Edge Check: what the screen can't see
Every original strategy leaves something to judgement that no screen can measure. The Edge Check is ValuJack's answer: before a card is dealt, an AI research agent reads the company's latest reports, official filings and news, and asks the one question that matters most for this strategy.
The QUEEN question: Is the high return on capital real and lasting?
The Magic Formula uses a single year of operating profit. A company at the top of its cycle, or one whose capital was shrunk by write-downs, can look like a great business for the wrong reasons.
Counts in favour
- A lasting advantage visible in the reports: pricing power, recurring revenue or a strong market position
- Revenue still growing
Counts against
- Margins far above the company's own long-run level, a sign of a cyclical peak
- Returns flattered by write-downs that shrank the capital base
- Revenue down two years running
- Regulation or a key contract threatening profits
- The share price is still falling
Checked for every card
- Insider trades: are the company's own managers buying or selling shares with their own money? Awards, option exercises and routine trades are ignored.
- Short sellers: are professional investors betting against the company, and is that bet growing?
- Report wording: has anything changed since last year in the risks, targets, dividend policy, accounting rules or the auditor's report?
- Customers, suppliers and peers: what have they said about demand since the company's own latest report?
- Management's record: have they met their own targets, and have the finance chief or the auditor left unexpectedly?
- The latest report: a clear beat or miss, and has guidance been raised or cut?
What stops a card outright
A profit warning, a takeover bid, a trading suspension, profits not backed by cash, doubt about the company's future or a qualified audit opinion, restated accounts, a large new share issue, a regulator investigating the accounts, or an unanswered fraud allegation from short sellers.
Argue the opposite
Before any verdict, the agent writes down the three strongest reasons this card could fail within the strategy's time frame, and looks for evidence on each. A reason that is confirmed counts against the company, or stops it.
How it changes the cards
Every trading day the best-ranked companies in each tier are checked. A stop removes a company; the other signals move companies up or down the order, and the best-placed company that passes is dealt. A company due to report within the next week usually waits until after its report. Open a card's details to see its Edge Check: the question, a short answer, up to three signals marked ✓ or △, what would break the case, and the date it was checked.
Every point needs a source and a date: the company's own reports, official registers of insider trades and short positions, and exchange news. Forums, social media and analysts' price targets never count, and a source that can't be reached counts as no signal, not as good news. The Edge Check never changes the fair value or the star rating, and never says buy or sell. It is research done by an AI agent under fixed rules, live since 28 October 2026; it can miss things or be wrong.
Questions people ask
Does the Magic Formula still work?
It has beaten the market in many independent tests, including several in Europe, but by much less than Greenblatt's 30.8% a year, and with stretches of two or three years when it lagged.
Why does the Magic Formula exclude banks and utilities?
Their finances don't fit the two measures. A bank's debt is its raw material, and utilities are regulated businesses with very different capital needs.
Is the Magic Formula the same as value investing?
It is value investing with a quality filter built in: it only wants cheap companies that also earn a high return on their capital. Pure value strategies, like the ones behind our ACE and TWO cards, don't require that.
Sources
- Greenblatt, J. (2005, updated 2010). The Little Book That (Still) Beats the Market. Wiley.
- Magic Formula Investing: How it works
- AAII: Magic Formula Stocks
- Alpha Architect (Wesley Gray): How magic is the Magic Formula?
- Quant Investing: Magic Formula back-tests, including Europe
- NHH master's thesis: the Magic Formula on the Oslo Stock Exchange, 2003–2022
- Stockopedia: How does Magic Formula investing work?
- The Motley Fool: book review of The Little Book That Beats the Market (2007)
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