Earnings Yield (EY)

EBIT divided by Enterprise Value (market cap + debt − cash). Higher is better — it means you’re getting more operating profit per dollar of total firm value. Greenblatt preferred this over P/E because it accounts for debt and uses operating income rather than net income.

Return on Capital (ROC)

EBIT divided by invested capital (net working capital + net fixed assets). Higher is better — it measures how efficiently a company generates profit from the capital deployed in the business. Companies with persistently high ROC tend to have durable competitive advantages.

Combined Rank

Each stock is ranked 1–N on EY (rank 1 = highest yield) and 1–N on ROC (rank 1 = highest return on capital). The combined rank is the sum of the two ranks. Lower combined rank = better Magic Formula score. A stock ranked #5 on EY and #8 on ROC scores 13 — better than a stock ranked #2 on one metric but #30 on the other.

Why It Works

By combining both metrics, the formula avoids the trap of buying cheap junk (high EY but poor business quality) or overpaying for quality (high ROC but expensive). In backtests, Greenblatt found the combined approach outperformed the S&P 500 over 17 years (1988–2004) by roughly 2× annually.