By Maksym Lytvynov, Founder of AlphaStocks | Last updated: March 2026
Greenblatt Magic Formula: Cheap Quality Stocks in Two Factors
Joel Greenblatt, a Columbia Business School professor and founder of Gotham Capital, introduced the Magic Formula in his 2005 book The Little Book That Beats the Market. The premise is elegant: rank every stock by how cheap it is (earnings yield) and how good the underlying business is (return on capital), then buy the stocks that rank highest on both factors combined. Greenblatt's backtests showed this strategy returned approximately 30% annually from 1988 to 2004.
What Are the Two Factors?
The Magic Formula distills stock selection into two complementary metrics, each capturing a distinct dimension of investment attractiveness:
Earnings Yield = EBIT / Enterprise ValueMeasures how cheap a stock is relative to its total value (equity + debt - cash). Higher is better. Using EBIT instead of net income and EV instead of market cap neutralizes differences in tax rates and capital structure.
Return on Capital = EBIT / (Net Fixed Assets + Working Capital)Measures how efficiently the business converts tangible capital into operating earnings. Higher is better. Companies that generate large profits from little invested capital have a structural competitive advantage.
Why Use EBIT Instead of Net Income?
Net income is distorted by three things that have nothing to do with the quality of the business: the amount of debt a company carries, the tax jurisdiction it operates in, and one-time items like asset write-downs or legal settlements. EBIT (Earnings Before Interest and Taxes) strips all of these away, leaving a purer measure of operating profitability.
Similarly, Enterprise Value (market cap + total debt - cash) replaces market cap in the earnings yield formula. This ensures that two companies with identical operating earnings are valued consistently regardless of whether one is debt-free and the other is leveraged.
How Does Percentile Ranking Work?
The Magic Formula does not use absolute thresholds. Instead, it ranks every eligible company in the universe on each factor from best (rank 1) to worst:
Step 1: Rank by Earnings Yield
All general-sector companies in the coverage universe are sorted by earnings yield from highest to lowest. The highest-yield stock gets rank 1.
Step 2: Rank by Return on Capital
The same companies are independently sorted by return on capital. The most efficient capital allocator gets rank 1.
Step 3: Combine Rankings
Each stock's two ranks are added together. The lowest combined rank indicates the best combination of cheapness and quality. A stock ranked 5th on earnings yield and 10th on return on capital has a combined rank of 15.
Example: Company A ranks 3rd on earnings yield and 12th on return on capital (combined: 15). Company B ranks 20th and 2nd (combined: 22). Company A scores higher despite having a lower return on capital, because it is significantly cheaper relative to earnings.
Why Are Banks, REITs, and Utilities Excluded?
Greenblatt himself excluded financial companies and utilities from the Magic Formula. The reason is structural: EBIT is not a meaningful metric for these businesses.
| Sector | Why EBIT Fails |
|---|---|
| Banks | Interest income is the core business, not something to exclude. EBIT strips away the entire revenue model. |
| REITs | Massive depreciation charges distort EBIT. FFO (Funds From Operations) is the standard profitability metric. |
| Utilities | Rate-regulated earnings make EBIT comparisons misleading. Capital structure is dictated by regulators. |
| Insurers | Underwriting profit and investment income do not map cleanly to EBIT. Combined ratio is the relevant metric. |
| Asset Managers | Revenue swings with AUM and market performance, making single-period EBIT snapshots unreliable. |
On AlphaStocks, the Magic Formula contributes to the Value axis only for companies in the general sector. For excluded sectors, the Value axis relies more heavily on Graham fair value and Lynch PEG models with sector-specific adaptations.
How AlphaStocks Uses the Magic Formula
In the AlphaStocks composite scoring system, the Greenblatt Magic Formula accounts for 30% of the Value axis. The Value axis carries 15% of the total composite weight, making the Magic Formula responsible for approximately 4.5% of the final score for general-sector companies.
It complements Graham fair value (45% of Value) and Lynch PEG (25% of Value). While Graham looks at asset-based intrinsic value and Lynch evaluates growth-adjusted pricing, Greenblatt focuses on operating efficiency relative to total enterprise value — three distinct lenses on the same question: is this stock cheap?
Value = Graham × 0.45 + Greenblatt × 0.30 + Lynch PEG × 0.25You can see each component's contribution on any stock detail page in the AlphaStocks screener. Registered users get full breakdowns showing the raw earnings yield, return on capital, and percentile rank.
Limitations
The Magic Formula is backward-looking. It uses the most recent trailing twelve months of EBIT, which may not reflect current business conditions. A company entering a downturn may still show strong historical earnings yield and return on capital for several quarters before the deterioration appears.
Percentile ranking is also sensitive to the composition of the universe. Greenblatt originally applied it to a broad market of 3,500 stocks. AlphaStocks now ranks across 1,595 stocks, which provides a broader distribution than the S&P 500 alone, but small differences in absolute values can still produce large rank differences.
This is precisely why AlphaStocks does not rely on the Magic Formula in isolation. It is one input within a multi-model composite that includes quality, momentum, and timing dimensions, each designed to compensate for the blind spots of the others.
Related Guides
This article is for educational purposes only. AlphaStocks provides algorithm-generated research tools, not personalized investment advice. The Greenblatt Magic Formula is one component of a multi-factor scoring system. Past performance, including Greenblatt's historical backtests, does not guarantee future results. Always conduct your own due diligence and consult a qualified financial adviser before making investment decisions. Data sourced from SEC EDGAR filings.