Lesson 5 of 7
Greenblatt's two ratios
Compute Greenblatt's earnings yield and return on capital exactly as defined, and see why a rank is not a threshold.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- Greenblatt's earnings yield is EBIT over enterprise value; his return on capital is EBIT over net working capital plus net fixed assets.
- The formula ranks every company on both ratios, adds the two rank numbers, and sorts by the total, from the best combined score down.
- A rank orders a list and sets no floor, so a company mediocre on one ratio can still finish near the top if the other is strong enough to compensate.
Joel Greenblatt's magic formula ranks every company in a universe on two ratios, adds the ranks together, and buys from the top of that combined list. Both ratios are defined precisely, and neither is the one most readers would guess.
Where a company sits on both of Greenblatt's ratios
RowsReturn on capitalColumnsEarnings yield
High, Low
Good business, priced up
High, High
Cheap and good
Low, Low
Weak and expensive
Low, High
Cheap for a reason
The two ratios, precisely defined
Earnings yield equals EBIT divided by Enterprise value.
Example$100m ÷ $1,000m = 10%
Return on capital equals EBIT divided by Net working capital + net fixed assets.
Example$100m ÷ ($150m + $350m) = 20%
Earnings yield uses EBIT over enterprise value rather than earnings over price. Enterprise value adds debt and subtracts cash, so two businesses with identical operating profit but different amounts of borrowing do not get different scores purely because of how they are financed.
Return on capital divides the same operating profit by the actual capital the business needs to run day to day and hold its fixed assets, leaving out cash and interest-bearing debt on the other side of the ledger. The capital base also leaves out goodwill and excess cash, so it measures the tangible capital the business needs to operate. A business that earns the same operating profit with less of that capital tied up scores higher here, which is the point: the ratio rewards efficiency, not just size.
Ranking is not screening
The formula does not require a company to clear a minimum on either ratio. It ranks every company from best to worst on earnings yield, ranks them again on return on capital, and adds the two rank positions together. Sorting by that total is a different operation from requiring each ratio to clear a floor, even though both are described, loosely, as using the same two figures.
His earlier book, You Can Be a Stock Market Genius (1997), covers different terrain entirely: special situations such as spin-offs and mergers, not the ranked screen here.
Where the rank and a floor disagree
Check yourself
Greenblatt's earnings yield divides EBIT by which figure?
- Share price
- Enterprise value
- Book value of equity
Show the answer
Answer: B.
Earnings yield is EBIT over enterprise value, which keeps the figure neutral to how the business is financed.What does Greenblatt's return on capital divide EBIT by?
- Total assets
- Net working capital plus net fixed assets
- Shareholders' equity
Show the answer
Answer: B.
The denominator is net working capital plus net fixed assets, the capital the operating business itself employs.Why is ranking on two ratios and adding the ranks not the same as screening on both?
- Because ranking uses different formulas for the two ratios
- Because a rank sets no floor, so a weak score on one ratio can be offset by a strong score on the other
- Because a rank can only be applied to one ratio at a time
Show the answer
Answer: B.
A threshold screen requires each ratio to individually clear a bar. A combined rank lets an exceptional score on one ratio compensate for a mediocre score on the other.Sources
- Greenblatt, The Little Book That Beats the Market, 2005: earnings yield and return on capital, precisely defined.
- Greenblatt, You Can Be a Stock Market Genius, 1997: special situations, including spin-offs, rights offerings, merger securities and bankruptcies.
What this leaves out
- The company in the worked example and the four companies in the rank table are illustrative, not any filed company's figures.
- The formula says nothing about debt covenants, accounting quality or whether the current return on capital will persist.
- A published magic-formula screen's exact universe and rebalancing rules vary by provider; this page reports the two ratios as Greenblatt defined them, not any one implementation.
- Greenblatt ran the ranking with financial companies and utilities excluded and a minimum company size; the two ratios do not work for banks.
- Nothing here is advice about any security.