The Magic Formula was developed by Joel Greenblatt in his book, ‘The Little Book That Still Beats the Market’. The basic idea behind the rank is to identify good businesses that are selling at attractive prices. This is done through the use of two ratios:
- Return on Invested Capital (ROIC) - which is calculated as EBIT / (Net Working Capital + Net Fixed Assets)
- Earning Yield - which is calculated as EBIT / Enterprise Value.
The rank then combines these two ratios to give you a list of companies with good businesses that are trading at an attractive price.
Kindly note that we tested the Magic Formula based on our interpretation of it after reading Joel Greenblatt’s book mentioned above. Neither Mr Greenblatt nor the website (magicformulainvesting.com) have endorsed this study or have had anything to do with it, or recommended any of the companies included in our back tests. We also made use of our own database and did not have access to Mr Greenblatt's
As you can see, the Magic Formula is a strong factor that leads to substantial market outperformance. Q1 performs better than Q5, and the results are completely linear. It is, however, not that consistent - outperforming the market 50% of the time for small companies and 58% of the time for mid and large companies.