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One of the sorting criteria in Joel Greenblatt's Magic Formula is EBIT. However, EBIT is positively correlated with the market capitalization of companies, i.e., larger companies have a higher EBIT. Nonetheless, even though EBIT might be high for some large companies, their EBIT/capitalization ratio may be lower than for some smaller companies, and the latter would be more attractive to invest in. Therefore, is it fair to say that the magic formula is (at least partly) biased towards large companies?

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  • Personally I'd suggest avoiding anything with "magic" in its name.
    – keshlam
    Jan 14 at 16:48
  • @keshlam, I agree with the criticism, but there’s truth to the methodology from a value-investing perspective. Jan 15 at 7:12

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According to this site,

The Magic Formula, as explained by Joel Greenblatt in his book The Little Book that Beats the Market, involves ranking stocks based on two metrics: earnings yield (EBIT/enterprise value) and return on capital (EBIT/invested capital).

Both of these metrics involve normalizing EBIT with respect to some other metric (enterprise value and invested capital). Basically, earnings yield and return on capital are modified versions of ROI. Both of these normalizing factors track the size of the company, and are correlated with market capitalization. So there isn't a clear bias towards large cap companies (there could be one empirically, but there isn't clear evidence of one just from the definition).

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