The Magic Formula is a stock selection strategy developed by Joel Greenblatt in his 2005 book The Little Book That Beats the Market. It ranks stocks on two metrics — earnings yield and return on capital — and invests in the top-ranked companies. The strategy is systematic, requires no forecasting, and can be implemented entirely with a stock screener.
Back-tests in European markets show the strategy outperformed the market by 152% over 12 years (1999–2011). Combined with a price momentum overlay, the same strategy returned +783% vs. +30.5% for the European market benchmark over the same period.
This guide explains how the Magic Formula works, how to adapt it to European equity markets, and how to implement it using a screener.
What is the Magic Formula?
Greenblatt's Magic Formula ranks every stock in a universe on two dimensions:
1. Earnings Yield = EBIT / Enterprise Value
Earnings yield measures how cheaply you are buying the company's earnings, adjusted for its capital structure. EBIT (earnings before interest and taxes) is used instead of net income to enable comparison across companies with different debt levels and tax situations. Dividing by enterprise value (market cap + net debt) instead of market cap makes the comparison capital-structure-neutral.
Higher earnings yield = cheaper stock.
2. Return on Capital = EBIT / (Net Working Capital + Net Fixed Assets)
Return on capital measures the quality of the business — how much profit it generates from the capital it has deployed. Companies with high return on capital typically have a competitive advantage: pricing power, proprietary technology, brand, or cost advantage that lets them earn more from each unit of invested capital than their competitors.
Higher return on capital = better business.
The combination: Both metrics are ranked for every stock in the universe. The two rankings are summed. The stocks with the best combined rank — cheap AND high quality simultaneously — form the Magic Formula portfolio.
Greenblatt's original implementation:
- Buy the top 20–30 combined-rank stocks
- Hold each position for 12 months
- Rotate annually
Why the Magic Formula works in European markets
The original Magic Formula was developed for US equities. European back-tests show it works — and for structural reasons that are arguably stronger in Europe than in the US:
Less analyst coverage in European mid and small caps. The pricing inefficiency that makes systematic value + quality strategies work is more pronounced where fewer analysts are watching. A German industrial with €300M market cap and two analysts is more likely to be mispriced than an S&P 500 company with 25 analysts.
The European valuation discount. European stocks trade at a persistent discount to US equivalents. This means the earnings yield component — which screens for cheap stocks — surfaces more candidates in Europe than in a US screen using the same thresholds.
Real-economy sector dominance. European indices are heavier in industrials, manufacturing, chemicals, and business services — sectors where return on capital is a more meaningful discriminator than in US tech-heavy markets where capital is largely intangible.
Back-test results:
- Europe (1999–2011): +152% vs. market benchmark over the period
- Benelux (20-year period): €10,000 grew to €113,238 under Magic Formula vs. €27,182 for the market (11.3x vs. 2.7x)
- Combined with momentum (12-month price return overlay): +783% vs. +30.5% for European market
How to run the Magic Formula screen in 2026
The exact Magic Formula uses EBIT/EV (earnings yield) and EBIT/(NWC + Net Fixed Assets) (return on capital). Most standard screeners provide approximations. Here is a practical implementation:
Step 1 — Choose your universe
The Magic Formula works best with a defined universe to prevent survivorship bias and outlier distortion. Suggested starting universes for Europe:
- All European exchanges, market cap > €100M — broad universe, thousands of candidates
- Major European exchanges only (XETRA, Euronext Paris, BME, Borsa Italiana, Euronext Amsterdam), market cap > €200M — more liquid names, easier execution
Exclude: banks, insurance, and other financial companies where return on capital is not comparable (use ROE-based metrics instead). Exclude: regulated utilities where capital allocation is government-constrained.
Step 2 — Filter for the cheapest stocks by earnings yield
Use EV/EBIT (sort ascending) or equivalently earnings yield = EBIT/EV (sort descending). Practical filter: EV/EBIT below 12 as a starting threshold.
If your screener provides EV/EBITDA but not EV/EBIT: EV/EBITDA is an acceptable approximation, particularly for asset-light businesses. For capital-intensive companies, EV/EBIT is more accurate.
Threshold: EV/EBIT below 12 (or EV/EBITDA below 8–10 as a proxy)
Step 3 — Filter for the highest-quality businesses by return on capital
Return on Invested Capital (ROIC) is the closest standard screener approximation to Greenblatt's return on capital metric.
Threshold: ROIC above 15%
The combination of high ROIC (quality) and low EV/EBIT (cheap) is the essence of the Magic Formula.
Step 4 — Combine and sort
Apply both filters simultaneously:
- EV/EBIT < 12 (or EV/EBITDA < 10)
- ROIC > 15%
Sort results by EV/EBIT ascending (cheapest to most expensive). The top 20–30 results are your Magic Formula candidates.
Step 5 — Apply basic exclusions
Exclude from the results:
- Companies in financial distress (negative equity, interest coverage below 1.5x)
- Companies with earnings that are clearly non-recurring (one-off asset sales, litigation settlements inflating EBIT)
- Very small or illiquid companies where execution is difficult
Step 6 — Equally weight and hold 12 months
Greenblatt's original implementation uses equal weights across positions, with 12-month holding periods and annual rotation. This minimizes transaction costs while capturing the mean reversion that makes the strategy work.
Sectors that screen well for Magic Formula in Europe
The highest concentration of Magic Formula candidates in European markets tends to cluster in:
German and Austrian industrials — Precision manufacturers, automation components, specialty coatings. High ROIC from dominant niche positions; often cheap because of index exclusion and low analyst coverage. See German Hidden Champions Screening.
Nordic industrial services — Scandinavian companies in facility management, testing, environmental services often combine high ROIC (sticky recurring contracts, high switching costs) with low valuations relative to their quality.
French mid-cap industrials — The Euronext Paris ecosystem below CAC 40 contains a large number of industrial businesses with 15–25% ROIC that screen cheaply relative to earnings. EGM and Euronext Growth listings extend this universe.
Italian specialty businesses — Manufacturing, packaging, specialty chemicals. Italy has a deep base of family-controlled businesses with excellent return on capital that trade at significant discounts to equivalent US or German businesses.
Sectors to avoid in Magic Formula screens:
- Banks and insurance (return on capital is not meaningful)
- Airlines and shipping (cyclically distorted ROIC at any point in the cycle)
- Mining and resources (cyclical EBIT makes earnings yield meaningless at peaks)
- Loss-making companies (EV/EBIT undefined or negative)
Magic Formula + momentum: the enhanced version
The most compelling Magic Formula research for Europe combines the strategy with a price momentum filter. The rationale: the Magic Formula identifies undervalued quality businesses, but timing the purchase matters. Buying names where the market is already beginning to recognize the value — indicated by positive price momentum — improves the entry and reduces the average holding period.
Implementation:
- Run the full Magic Formula screen as described above
- From the top 30 candidates, filter for stocks with positive 6-month price return (or 12-1 month momentum: 12-month return excluding the most recent month)
- Invest in the intersection: cheap, high quality, and with improving price trend
Back-tests in European markets show this combined approach returns significantly more than either factor alone, at the cost of buying fewer names and requiring monthly rebalancing.
Magic Formula vs. pure value investing
| Dimension | Pure Value (P/E, P/B) | Magic Formula |
|---|---|---|
| Valuation metric | P/E, P/B (earnings/book-based) | EV/EBIT (earnings yield, capital-structure-neutral) |
| Quality requirement | None | Yes — ROIC must be high |
| Value traps | High — cheap stocks include deteriorating businesses | Lower — ROIC filter excludes poor-quality businesses |
| Sectors avoided | None explicitly | Banks, insurance (ROIC not comparable) |
| Holding period | Variable | 12 months (annual rotation) |
| Key risk | Value trap, no exit discipline | Growth businesses with temporarily compressed ROIC |
The Magic Formula is a quality-adjusted value strategy. It avoids the pure value trap problem (cheap but deteriorating) by requiring high ROIC. The cost is that genuinely cheap but low-quality businesses — turnaround situations, restructuring plays — are excluded.
Practical notes for European implementation
Language barrier for smaller names. The most interesting Magic Formula candidates in Europe are often German, Italian, or French companies with annual reports not available in English. Basic financial metrics are accessible through any screener; deep qualitative research may require translation tools.
Liquidity. European mid and small-cap markets have lower average daily volumes than US equivalents. Build positions over several weeks rather than all at once for names below €500M market cap.
Dividend tax. Annual portfolio rotation involves significant dividend events depending on holding period. Account for withholding tax implications for European stocks paying dividends during the 12-month holding period.
Transaction costs. Broker fees for European exchanges vary widely. Fractional shares are not universally available for European stocks. Factor transaction costs into the portfolio construction — the Magic Formula works best with 20+ positions held for 12 months, not with 5 positions turned over monthly.
Frequently asked questions
Does the Magic Formula work in European markets?
Back-tests show the Magic Formula outperformed European market benchmarks by 152% over a 12-year period (1999–2011). Combined with price momentum, the outperformance was more dramatic. As with any systematic strategy, past back-test performance does not guarantee future results — but the underlying logic (buy quality at a discount) has economic foundations that are unlikely to disappear.
What is the best screener for the Magic Formula in Europe?
You need a screener with EV/EBIT (or EV/EBITDA as an approximation) and ROIC filters that work reliably for European stocks including small and mid-caps. ScreenerHero covers all European exchanges with these filters working at microcap level.
Can I run the Magic Formula on large European stocks only?
Yes. Greenblatt's original implementation excluded small caps below $50M market cap (his rationale: too illiquid for most investors). For European markets, a €200–500M market cap floor reduces liquidity risk without significantly limiting the universe size.
How many stocks should a Magic Formula portfolio hold?
Greenblatt recommends 20–30 stocks for sufficient diversification. For European markets specifically, 20–25 positions across multiple countries and sectors is a practical target — enough diversification to avoid single-stock risk while keeping the portfolio manageable.
How often should I rebalance a Magic Formula portfolio?
Annual rebalancing at the 12-month mark is Greenblatt's recommendation. More frequent rebalancing increases transaction costs without meaningful performance improvement based on historical back-tests.
Run the Magic Formula screen on European stocks → — filter by EV/EBITDA and ROIC across all European exchanges. Free, no account required.