The magic formula: good and cheap, ranked together

Imagine Asha is buying a second-hand cycle. She could ask just one question: "Is this a good cycle?" But a good cycle sold at a silly-high price is still a bad buy. Or she could ask a different single question: "Is this cycle cheap?" But a cheap cycle that is rusted and broken is a bad buy too. The smart thing is to ask both questions together: "Is this a good cycle, and is it going for a fair, low price?" Only when the answer to both is yes has she found a real bargain.

Joel Greenblatt turned this simple, obvious idea into what he cheerfully called the magic formula. It is not magic at all - that name was a bit of a joke. It is just the two-question test, applied to companies instead of cycles. To find a good business at a cheap price, he said, you look for a company that is good (it earns a lot of money on the money it uses) and cheap (you do not have to pay much for the profit it makes). Not one. Both, together.

This study is about those two measures and why putting them side by side is the whole trick. A "good" business tells you the quality is there. A "cheap" price tells you the deal is there. Greenblatt's point was that most people fall in love with one and forget the other - and the magic, such as it is, comes only from insisting on both at once.

Let us define the two words plainly.

Good means the business earns a lot on the money it puts to work. Think of a kirana shop that uses ₹100 of goods and shelves and earns ₹30 a year from them. That is a return on capital of about 30% - thirty rupees of profit for every hundred rupees the business needs to run. A different shop might earn only ₹8 on the same ₹100. The first shop is "good" in Greenblatt's sense: it squeezes a lot of profit out of the money it uses. High return on capital is the mark of a strong little money-machine.

Cheap means you do not pay much for that profit. If a company earns ₹40 of profit per share and its share costs ₹200, you are paying ₹5 for every ₹1 of yearly profit. If another company earns the same ₹40 but its share costs ₹800, you are paying ₹20 for every ₹1 of profit. The first is cheap; the second is dear. (People often flip this around and call it the P/E - the price you pay divided by the profit. A low number means cheap.)

Now the trick. Greenblatt said: take all the companies you can, and give each one two ranks. Rank them from most good to least good (by return on capital). Then rank them again from most cheap to least cheap (by price for profit). Then add the two ranks together. A company that is fairly good and fairly cheap will have a low combined rank and float to the top of the list - even if it is not the very best on either measure alone. That is the magic formula in one breath: rank by good, rank by cheap, add the ranks, look at the top. It quietly pushes you toward the top-right corner of the grid, where quality and price meet.

illustrative Suppose Arjun looks at three invented companies and measures each on the two questions.

Look at what happens. Sunrise Shop is the best business - 35% return on capital - but it is dear, costing ₹22 for every ₹1 of profit, so its cheap rank is poor. Ratna Tools is fairly cheap but a weak business, so its good rank is poor. Kavi Foods is not the best on either single measure - it is second on both. But because it is strong on both at once, its ranks add up to the lowest total, and it comes out on top. That is the whole point. The formula does not reward the flashiest business or the very cheapest share. It rewards the one that is solidly good and solidly cheap together - the top-right corner of the grid, found with simple arithmetic.

The name "magic" fools people. There is nothing magic here, and Greenblatt knew it. It is a rough, sensible way to sort companies - not a machine that prints money. Treating it as certain, and betting more than you can afford because it is "magic," is the fastest way to get hurt.

A single year's numbers can lie. Return on capital and price-for-profit are both worked out from reported figures, and those figures can be twisted for a year - a one-time sale can puff up profit, or an odd year can flatter a weak business. A company can look "good and cheap" on the surface while the truth underneath is different. The formula sorts the numbers; it cannot check whether the numbers are honest.

It works on a basket, over years - not on one pick, next week. Greenblatt never said "buy the top one and get rich by Diwali." His idea was to buy many of the top-ranked companies together and hold them for years, accepting that some will disappoint while the group, on average, does well. Anyone who picks a single name from the list and expects it to jump has misunderstood the whole thing. (That patience is its own study.)

The two questions - is it good, is it cheap - travel perfectly to India, because they are just common sense about buying anything. You can rank Indian companies by return on capital and by price-for-profit exactly the same way. But the warnings travel too, and matter more here. In our market, some companies' reported numbers deserve extra care; a business can look "good and cheap" on paper while its accounts hide trouble, or while its owners do not treat small shareholders fairly. A simple rank cannot see any of that. So the honest way to use this in India is as a first sieve - a way to shrink thousands of companies down to a shorter list worth studying by hand - never as a final answer that hands you names to buy. The arithmetic points you at the top-right corner. Reading each company carefully is still your job.

• Always ask both questions. Is the business good (high return on capital)? Is it cheap (low price for its profit)? One yes is not enough.
• Rank, then add. Rank companies on good, rank them on cheap, add the two ranks, and look at the top - the ones strong on both, not the best at either alone.
• Aim for the top-right corner. The prize is where quality and low price meet, not the flashiest business and not the very cheapest share.
• Check that the numbers are real. Before trusting a "good and cheap" score, make sure the profit is steady and honest, not a one-year trick.
• Think basket and years, not one pick. The idea is a group of top-ranked firms held patiently - never a single share expected to jump soon.