Greenblatt: The Magic Formula (Good Companies + Cheap Prices)

In The Little Book That Beats the Market, Joel Greenblatt introduced the Magic Formula. It distills the essence of value investing—"buy good companies, and buy them cheap"—into two quantifiable, rankable metrics.

Two Core Metrics

• Return on capital (ROIC ≈ EBIT ÷ tangible capital): measures how "good" the business is—how much it earns on each dollar of capital. The higher it is, the better the business quality and the wider the moat may be.
• Earnings yield (≈ EBIT ÷ enterprise value, EV): measures how "expensive" it is—effectively the inverse of the P/E, but using EV to include debt as well. The higher it is, the cheaper you are buying.

Why Look at "Both" Together

Look only at cheapness and you will buy a pile of poor companies that are "cheap for a reason" (value traps); look only at quality and you may overpay for good companies. The elegance of the Magic Formula is that it ranks all market stocks by each metric separately, then combines the ranks and picks those that score best on both—businesses that are both good and cheaply priced. This is precisely the quantified union of Graham's "cheapness" and Buffett's "quality."

“It makes sense to choose to buy good companies at cheap prices.”— Joel Greenblatt

Discipline Matters More Than the Formula

Greenblatt admits candidly that the Magic Formula can underperform the market for a year or two at a stretch—and it is precisely this "it stops working for a while" that makes most people give up, which is why the formula keeps working over the long run. This brings us back to psychology: any effective method requires the discipline to keep executing when it hurts in order to pay off.

How It Maps to Our Engine

The Magic Formula reminds us that valuation is always a two-dimensional problem of "quality" and "price"—you cannot look at just one dimension. When determining an action label, this platform's engine likewise incorporates both business quality (moat, returns) and price attractiveness (expected return vs. required return), rather than concluding on the basis of "looks cheap" or "looks good" alone.