Following the Magic Formula: Adding Two Rankings
The name suggests a secret; the substance is arithmetic. Rank every stock once by how cheaply it trades and once by how well it earns, then add the two ranks and start from the smallest sum. It is a mechanical way to surface companies that are cheap and good at business at the same time.
The structure of the original
Greenblatt's original uses two measures. Earnings yield asks how much operating profit the enterprise produces relative to its value, close to the inverse of PER, so higher means cheaper. Return on capital asks how much operating profit comes from the capital employed, so higher means a better business.
Rank the universe by earnings yield, rank it again by return on capital, and add the two ranks. A company ranked 1st on cheapness and 50th on quality (sum 51) beats one ranked 30th on both (sum 60).
A simplified version from public data
The original inputs require working through financial statements. A widely used shortcut keeps the skeleton with public metrics: rank cheapness by ascending PER, and rank quality by descending return on equity. If ROE is hard to source, approximate it with PBR ÷ PER, which is book-to-price times earnings-to-price, structurally the same ratio as ROE.
Example with three stocks: PERs of 8, 12, 20 and approximate ROEs of 12%, 15%, 8% give PER ranks 1·2·3 and ROE ranks 2·1·3. The sums are 3·3·6: the first two tie for the lead, the third trails. The structure scales to any universe size.
Caveats and a working order
The weak spot is cross-sector comparison. Structurally cheap sectors such as banking can sweep the top ranks, which is why the original excludes financials and utilities. Rank within a sector, or at least check whether one sector dominates the result.
A working order: build the PER ranking from the value screener, add the approximate ROE ranking from each stock page's PBR, keep the top of the combined list, then read money flow and the neglect index for returning attention. The ranking narrows candidates; the judgment comes from the checks after it.
Frequently asked questions
- Does buying strictly by the formula produce profits?
- No. The author himself documented multi-year stretches of trailing the market. The ranking is a starting point for surfacing cheap and well-run companies, not a device that promises outcomes.
- How many stocks should the list keep?
- The original was designed around diversification across 20 to 30 names. However far you narrow, concentrating on one or two names contradicts the premise of the method.
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