November 11, 2025
4 mins read
Magic Formula Investing is a simple, rule-based approach to value investing. Magic Formula Investing ranks companies on the basis of fixed criteria rather than using your gut or market noise. The idea is to focus less on emotions and more on actual numerical results.
The concept is simple: invest in good companies at fair prices, but with discipline. Joel Greenblatt, an investor and professor, introduced the method with the aim of making value investing easier to follow for everyday people.
The formula excludes small-cap, foreign, financial, and utility firms. It only looks at large-cap companies based in the U.S. The strategy repeats the same steps each year, helping you stay steady. Think of it as a system designed to keep you consistent rather than reactive.
By ranking companies and buying the top scorers, Magic Formula Investing creates a repeatable framework that keeps you organised and focused.
Joel Greenblatt described the method in his books The Little Book That Beats the Market and The Little Book That Still Beats the Market. He wanted to create a straightforward way for people to select stocks without being overwhelmed.
Instead of analysing every company from scratch, the formula screens and ranks them using two main measures.
Earnings yield is the first measure. It is calculated by dividing a company’s EBIT (Earnings Before Interest and Taxes) by its enterprise value. This shows how much profit the business generates relative to its total value.
Return on capital is the second measure. It is EBIT divided by net fixed assets plus working capital. This indicates how efficiently the business uses its resources to create earnings.
The plan is to invest in 20 to 30 of the high-ranked companies. Buy a few each month, keep them for a year, then sell losers just before the year ends and winners just after. Then repeat.
This format also accommodates tax regulations. Early selling losses can eliminate taxable gains. Holding winners for longer than a year allows long-term capital gain tax.
To summarise, the system takes out guesswork. You stick to a set process, aiming to avoid rash decisions driven by short-term market swings.
To follow Magic Formula Investing, there are some conditions to keep in mind:
Only consider firms with a market capitalisation above $50 million.
Exclude utility, financial, and non-U.S. companies.
Do not include ADRs.
Work out earnings yield: EBIT ÷ Enterprise Value.
Work out return on capital: EBIT ÷ (Net Fixed Assets + Working Capital).
Rank firms using both measures.
Pick the top 20 to 30.
Buy a few each month.
Rebalance after 12 months: sell losers just before, winners just after.
Continue this process for 5–10 years.
The approach does not rely on predicting markets. It simply applies fixed steps. Some studies indicate that it has performed well compared to benchmarks such as the S&P 500. More importantly, it teaches patience and consistency — both essential for long-term investors.
You can think of applying Magic Formula Investing as just applying the same such steps every year. You will invest in about 20 to 30 companies that score well against the formula. Then, instead of following trends, you are following numbers, and you continue in that cycle.
The process itself is to buy a few shares each month, hold them for about a year, and re-balance afterwards. It is designed to create discipline and structure in your investing journey.
The formula is built on two calculations. First, earnings yield, EBIT divided by enterprise value. This tells you how much profit a business produces compared to its size and valuation. Second, return on capital, EBIT divided by net fixed assets plus working capital. This tells you how well a business is using its capital to produce its earnings.
Magic Formula Investing has both strengths and weaknesses.
It's a straightforward process. No need for expert knowledge or heavy contemplation.
It limits the emotional aspect of decision-making since you will rely on logic and numbers instead of market noise.
It eventually leads you towards a disciplined and consistent way of investing.
Outcomes may vary as market behaviour changes. Past results are no guarantee.
The formula is basic. It does not consider factors like debt levels or dividends.
If many investors use the same approach, it could reduce its effectiveness over time.
In the end, it is not flawless. It simplifies investing but does not ensure consistent returns every year. Still, it offers a structured path for those who want less guesswork and more discipline.
Magic Formula Investing has a straight-forward structure and needs no greater analysis. Magic Formula Investing specifies pre-determined rules that fit a specified approach to investing: you also don’t need to predict the market.
For investors who prefer a mechanical approach, it may be a helpful tool.
Magic Formula Investing can’t guarantee excellent results every year, but it will reinforce an aspirational discipline of patience. If you adhere to the process for a few years, it will force you to develop value-investing habits which are helpful for long-haul investing.
Disclaimer: This article is for informational purposes only and does not constitute investment advice. Bajaj Broking Financial Services Ltd. (BFSL) makes no recommendations to buy or sell securities.
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Magic Formula Investing is an investing strategy based on rules that rank stocks based on their return on capital and earnings yield. You buy top-ranked companies in small batches, hold them for a year, and then repeat the process. It helps avoid emotional decisions.
Joel Greenblatt created Magic Formula Investing. He’s an investor, author, and professor. He introduced the strategy in his books and designed it to help people invest in a simple, consistent way without needing expert skills.
The two main metrics are earnings yield (formula: EBIT ÷ Enterprise Value) and return on capital (formula: EBIT ÷ Net Fixed Assets + Working Capital). These help rank companies by value and efficiency.
Start by screening for companies that meet the size and industry rules. Then rank them. Invest in 20 to 30 companies gradually. Rebalance yearly by selling losers early and winners later. Repeat this for at least 5–10 years.
Benefits include simplicity, discipline, and emotion-free decisions. Risks include inconsistent results and reliance on fixed rules. Market changes or too many people using the strategy may affect outcomes.
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