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Which price ratio outperforms the enterprise multiple?

May 01, 2012 | About:
Saj Karsan

Greenbackd

30 followers
Having just anointed the enterprise multiple as king yesterday, I’m prepared to bury it in a shallow grave today if I can get a little more performance. Fickle.

In their very recent paper, “Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years,” Wes Gray and Jack Vogel asked, “Which valuation metric has historically performed the best?

Gray and Vogel examine a range of price ratios over the period 1971 to 2010:

  • Earnings to Market Capitalization (E/M)
  • Earnings before interest and taxes and depreciation and amortization to total
  • enterprise value (EBITDA/TEV)
  • Free cash flow to total enterprise value (FCF/TEV)
  • Gross profits to total enterprise value (GP/TEV)
  • Book to market (B/M)
  • Forward Earnings Estimates to Market Capitalization (FE/M)
They find that the enterprise multiple is the best performing price ratio:

The returns to an annually rebalanced equal-weight portfolio of high EBITDA/TEV stocks, earn 17.66% a year, with a 2.91% annual 3-factor alpha (stocks below the 10% NYSE market equity breakpoint are eliminated). This compares favorably to a practitioner favorite, E/M (i.e., inverted Price-to-earnings, or P/E). Cheap E/M stocks earn 15.23% a year, but show no evidence of alpha after controlling for market, size, and value exposures. The academic favorite, book-to-market (B/M), tells a similar story as E/M and earns 15.03% for the cheapest stocks, but with no alpha. FE/M is the worst performing metric by a wide margin, suggesting that investors shy away from using analyst earnings estimates to make investment decisions.

The also find that the enterprise multiple generates the biggest value premium:

We find other interesting facts about valuation metrics. When we analyze the spread in returns between the cheapest and most expensive stocks, given a specific valuation measure, we again find that EBITDA/TEV is the most effective measure. The lowest quintile returns based on EBITDA/TEV return 7.97% a year versus the 17.66% for the cheapest stocks—a spread of 9.69%. This compares very favorably to the spread created by E/M, which is only 5.82% (9.41% for the expensive quintile and 15.23% for the cheap quintile).

Here are the results for all the price ratios (click to make it bigger):

gray-perf-table.jpg?w=500&h=343

Which price ratio outperforms the enterprise multiple? None. Vivat rex.

About the author:

Greenbackd
Saj Karsan founded an investment and research firm that is based on the principles of value investing. He has an MBA from the Richard Ivey School of Business, and an undergraduate engineering degree from McGill University.

Rating: 3.7/5 (9 votes)

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