How magic formula investing ranks companies

The name sounds like a shortcut to easy money, but the magic formula is really just a ranking method. This page explains how magic formula investing works, the two numbers it uses and why it needs care.

Quick answer

Magic formula investing is a rules-based method set out by investor Joel Greenblatt in 2005. It ranks companies on two measures: earnings yield, to find shares that look cheap, and return on capital, to find good businesses. Companies with the strongest combined rank are picked, held for about a year and then replaced. It does not guarantee returns.

Key takeaways

• The magic formula ranks companies on two numbers.
• Earnings yield checks if a share looks cheap.
• Return on capital checks if the business is good.
• It was described by Joel Greenblatt in 2005.
• The name does not mean it works every year.

What is magic formula investing?

It is a simple screen that combines value and quality. The goal is to find good companies at fair or low prices. Instead of reading every annual report, an investor ranks a list of companies using two numbers and picks those near the head of the list.

Joel Greenblatt, an American fund manager, wrote about the method in a 2005 book. He presented it as a disciplined, rules-based approach for ordinary investors.

The two measures used

Earnings yield uses EBIT, which is profit before interest and tax, and divides it by enterprise value. This lets you compare companies with different levels of debt on a fair basis.

Return on capital shows how much operating profit a company makes for each rupee of capital it uses. A high figure suggests a business with some advantage over rivals.

How does the magic formula work, step by step?

First, pick a group of companies above a minimum size. Leave out banks, financial firms and utilities, since their accounts work differently. Next, rank all companies by earnings yield and separately by return on capital.

Add the two ranks for each company. The lowest combined score ranks first. Buy around 20 to 30 of the highest-ranked companies over time, hold each for about a year, then repeat the screen and replace them.

What are the limits?

The method relies only on past numbers. It does not look at management, debt risks, one-time profits or changes in the industry. A company may look cheap because its profits are about to fall.

Results can vary a lot from year to year, and there can be long stretches when the method lags the market. Past performance is not indicative of future results. Sticking to any fixed rule through weak periods is also hard for most people.

The key point to remember

The magic formula is a useful screen that mixes value and quality in one ranking. Despite its name, it is not magic. It can be a starting point for research, not a replacement for it.

Frequently Asked Questions