Book guide · Joel Greenblatt
What Is The Little Book That Beats the Market About?
Joel Greenblatt’s book introduces a systematic way to look for companies that appear profitable relative to the capital they use and inexpensive relative to earnings. The method is a research framework, not a promise to beat the market.
Quick Answer: What is the Magic Formula?
Greenblatt’s Magic Formula ranks eligible companies using two measures: earnings yield, for how much operating earnings a business offers relative to its purchase price, and return on capital, for how efficiently it uses operating capital. A combined rank identifies candidates to examine. It does not establish that a company is safe, fairly priced, or suitable for a particular investor.
How does the book move from story to screen?
- Price and business value: a share price is observable; a company’s value is an estimate that depends on future results.
- Mr. Market: Greenblatt draws on Benjamin Graham’s metaphor to encourage independent evaluation of quoted prices rather than reacting to every move.
- Business quality: operating profit relative to capital is one way to ask how productive a business is. Accounting definitions and industry differences matter.
- Price paid: an earnings yield compares earnings with a measure of business value. Greenblatt’s definition is not the same as simply taking the inverse of a website P/E ratio.
- Combined ranking: a high rank on both measures can narrow a research list. A rank alone does not explain a one-time profit, debt risk, or an expensive acquisition.
- Patience and review: a rules-based strategy can lag a benchmark for long periods. Decide how to evaluate it before seeing a short run of returns.
Which of the old guide’s ideas need qualification?
The old guide treated a simple earnings-division formula as a full business valuation, called highly ranked companies usually good investments, and described strong future returns as proven. Future earnings, financing, taxes, and risk are uncertain. The SEC warns that a backtest applies rules to past market conditions and cannot predict future performance. A strategy should be compared with a relevant benchmark after fees and taxes, using the data and company list actually available at the time.
Why can a high score mislead?
Operating income can be temporarily high or low. Debt, cash, acquisitions, and accounting choices affect enterprise value and capital employed. A data provider may calculate a ratio differently from Greenblatt’s method. A screen also may exclude businesses that do not fit the method. Read current filings and the calculation definitions before interpreting a rank.
How can you use the idea as an educational exercise?
- Write the exact numerator and denominator you would use for earnings yield and return on capital.
- Find the corresponding filing figures and dates; note any missing or adjusted inputs.
- Compare two companies in the same industry before drawing a conclusion.
- Document the reason a high or low value might be temporary, and record what a simple screen omits.
Reproduce both ratios with Costco’s 2025 filing
Use Costco’s fiscal 2025 Form 10-K: the year ended August 31, 2025, income statement (page 37), balance sheet (page 39) and debt/lease notes (pages 52–54). Costco’s issuer historical quote tool reports a $943.32 close for August 29, 2025, the last trading session before that Sunday year-end. Select that date to reproduce the lookup. Sources checked October 8, 2026. This is a hindsight calculation using subsequently published accounts, not a screen available on August 29.
| Input / date | Amount |
|---|---|
| Fiscal 2025 operating income (EBIT proxy) | 10,383 |
| Aug. 31 common shares outstanding | 443.237 million |
| Aug. 29 closing price | $943.32 |
| Total current assets / current liabilities | 38,380 / 37,108 |
| Cash / short-term investments | 14,161 / 1,123 |
| Debt carrying amount, current + long-term | 5,788 (75 + 5,713) |
| Finance-lease liabilities, current + long-term | 1,479 (78 + 1,401) |
| Net property and equipment / finance-lease assets | 31,909 / 1,488 |
1. Earnings yield: operating earnings ÷ enterprise value
Market equity = $943.32 × 443.237 million shares = $418,114.33 million. For this defined version, add debt and finance-lease liabilities, then subtract cash and short-term investments: EV = 418,114.33 + 5,788 + 1,479 − 14,161 − 1,123 = $410,097.33 million. Earnings yield = 10,383 ÷ 410,097.33 × 100 = 2.53%. This is an operating-earnings yield, not a dividend yield, stock-return forecast or inverse net-income P/E.
2. Return on capital: operating earnings ÷ tangible operating capital
Remove financial cash/investments from current assets: 38,380 − 14,161 − 1,123 = 23,096. Remove current interest-bearing debt and finance-lease liabilities from current liabilities: 37,108 − 75 − 78 = 36,955. Operating net working capital = 23,096 − 36,955 = −13,859. Add net fixed assets including separately reported finance-lease assets: 31,909 + 1,488 = 33,397. Tangible capital = −13,859 + 33,397 = $19,538 million. Return on capital = 10,383 ÷ 19,538 × 100 = 53.14%.
These are explicit educational definitions: year-end rather than average capital; operating income as the EBIT proxy; debt at carrying amount; cash and short-term investments deducted in full. Finance-lease assets and liabilities are included once. Operating-lease right-of-use assets and long-term operating-lease liabilities are excluded from the fixed-capital/debt additions; operating lease expense remains in operating income. Goodwill and other intangibles are excluded. Short-term bank borrowings described as immaterial are omitted. Adjusting cash needs, leases or accounting items can change both ratios.
The negative operating working-capital component helps explain the high calculated return on capital; it does not establish low risk. A company can use operating capital efficiently while its quoted earnings yield is low. One company cannot supply a combined rank across an eligible stock universe. These calculations do not reproduce the official screener’s proprietary adjustments. The author-associated Magic Formula site describes its accounting adjustments and exclusions. Review definitions and business risks before interpreting a score.
Key takeaways
- Earnings yield compares operating earnings with a defined enterprise value.
- Return on capital depends on which operating assets and liabilities you include.
- A high ratio is a research input; one company’s ratios do not establish a rank or future return.
Check your understanding
1. What two ideas does the Magic Formula combine?
A. Dividend date and share split. B. Earnings yield and return on capital. C. Yesterday’s price and volume only.
Show answer and feedback
B. The framework asks about price relative to operating earnings and operating earnings relative to capital.
2. Is a website P/E ratio necessarily Greenblatt’s earnings-yield measure?
A. Yes. B. No. C. Only when the share price rises.
Show answer and feedback
B. Greenblatt’s calculation uses specific operating-earnings and enterprise-value definitions; a P/E ratio uses different inputs.
3. What can a backtest establish?
A. Guaranteed future outperformance. B. How stated rules would have performed on past data under the test’s assumptions. C. A stock’s future price.
Show answer and feedback
B. Historical tests describe the past and depend on data quality, costs, and the test design.
Why question: Why should you inspect a company’s filing after it appears near the top of a ranking?
Show a sample explanation
The rank may depend on unusual earnings, debt, or a data definition. A filing helps you understand the inputs and risks behind a simple score.
Try it: inspect the inputs behind a ranking
Open the SEC EDGAR search prefilled for Apple and find its latest 10-K. Locate operating income in the statement of operations, then note the reporting period. Write down which additional debt, cash, and capital inputs you would need to reproduce the book’s ratios. This is a filing-reading exercise, not a Magic Formula score or an Apple recommendation.
Where can you check the sources?
- Wiley: Joel Greenblatt’s book and updated edition
- SEC Investor.gov: Performance Claims and Backtesting
- FINRA: Investment Strategies
- SEC Investor.gov: Using EDGAR to Research Investments
End of Book Guide
AI responses are for educational purposes. Always verify with official course materials.
This lesson teaches a concept. It is general education, not advice about your money. Before you act on anything you learn here, speak to someone licensed.
AI responses are for educational purposes. Always verify with official course materials.
This lesson teaches a concept. It is general education, not advice about your money. Before you act on anything you learn here, speak to someone licensed.
This lesson teaches a concept. It is general education, not advice about your money. Before you act on anything you learn here, speak to someone licensed.
