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)