By Maksym Lytvynov, Founder of AlphaStocks | Last updated: 2026-09-23
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.
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 what the whole business costs: market cap plus debt, preferred stock and minority interest, less the cash the business does not need to operate. 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. Working capital excludes cash and short-term debt and cannot go below zero; goodwill and other intangibles are left out. 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 + debt + preferred + minority interest − excess 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 eligible 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.
Every eligible company is ranked by earnings yield (highest = 1) and by return on capital (highest = 1); the two ranks are added and the list ordered by the sum, ties going to the higher earnings yield. The 0–10 score is 10 × the share of the eligible universe ranked below the company. Status bands: Strong: combined rank in the top 20%; Attractive: the next 20%; Neutral: the middle 30%; Reject: the bottom 30%.
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.
| Profile | Ranked? |
|---|---|
| General | Yes |
| Bank | Not applicable — Greenblatt does not rate banks |
| Insurer | Not applicable — Greenblatt does not rate insurers |
| Asset manager | Not applicable — Greenblatt does not rate financial companies: EBIT and working capital mean nothing for a balance sheet that is the business |
| Holding company | Not applicable — Greenblatt does not rate financial companies: EBIT and working capital mean nothing for a balance sheet that is the business |
| Utility | Not applicable — Greenblatt does not rate utilities |
| REIT | Not applicable — Greenblatt does not rate REITs: their real estate is the capital, so return on capital is a property yield |
Utilities and financial companies are left out, as the book does; REITs too, because their real estate is the capital and return on capital becomes a property yield.For an excluded company the Value axis is the average of the Value models that do apply — Graham and, except for banks and insurers, Lynch.
How AlphaStocks Uses the Magic Formula
In the AlphaStocks composite scoring system, the Greenblatt Magic Formula carries 30% of the Value axis in the general profile. The Value axis carries 10% of the composite and also sets the Timing axis (15%), the lower of Value and Momentum.
It complements Graham fair value (45% of Value) and Lynch PEG (25%of Value). While Graham checks the defensive investor's seven criteria 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 × 0.3 + Lynch × 0.25 (general profile)You 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 ranks.
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.
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 1,500+ 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.
Frequently Asked Questions
What is the Greenblatt Magic Formula?
The Magic Formula, introduced by Joel Greenblatt in "The Little Book That Beats the Market" (2005), ranks stocks using two factors: Earnings Yield (EBIT / Enterprise Value) and Return on Capital (EBIT / Net Fixed Assets + Working Capital). Stocks that rank highest on both factors combined are considered the best opportunities.
Why does the Magic Formula use EBIT instead of net income?
EBIT (Earnings Before Interest and Taxes) removes the effects of different tax rates and capital structures, allowing fair comparison between companies with different debt levels. A heavily leveraged company and a debt-free company can be compared on their core operating profitability.
Does AlphaStocks apply the Magic Formula to all stocks?
No. As the book does, AlphaStocks leaves out utilities and financial companies — banks, insurers, asset managers and holding companies — and REITs too, because their real estate is the capital and return on capital becomes a property yield. For them Greenblatt is reported as not applicable and left out of the Value axis, never scored as zero.
How does AlphaStocks use the Magic Formula in scoring?
Every eligible company is ranked by earnings yield and by return on capital, and the two ranks are added, as the book does. The 0–10 score is 10 × the share of the eligible universe ranked below the company, and the status bands are: Strong: combined rank in the top 20%; Attractive: the next 20%; Neutral: the middle 30%; Reject: the bottom 30%. Greenblatt carries 30% of the Value axis in the general profile; the Value axis carries 10% of the composite.
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.