Trying to value stocks is a difficult process. The key is having a set, repeatable process that you can use time and again to continue to generate steady returns.
With such criteria needed, many investors find themselves turning to quantitative strategy, investing according to a set of fixed ratios and rebalancing after a set period. Qualitative, more fundamental analysis such as management interviews is forgone in favor of putting trust in the figures.
As it is always difficult to gauge qualitative factors, the quantitative approach has gained ground over the past few decades. Now, a huge portion of the investment industry follows this approach. But despite all the resources being pumped into quantitative trading strategies, the presence of one key strategy that can be relied upon to achieve steady outperformance year after year remains elusive. Indeed, even the number of valuation metrics has not decreased over the past few decades. If anything, the number of ways to value stocks has only increased, making life much harder for those investors trying to find one strategy to rule them all.
This strategy may already exist, however, although the fact it has not been widely recognized is probably why it continues to outperform.
One strategy to rule them all?
The strategy I am talking about is the EBITDA/TEV ratio.
In the Fall of 2012, Wesley Gray and Jack Vogel published a research paper looking at the performance of several different valuation strategies in the stock market over the past four decades. What they found was that during the analyzed period of 1971 through 2010, EBITDA/TEV achieved by far the best performance of any other metric with an annually rebalanced, equal weight portfolio, with high EBITDA/TEV stocks earning 17.66% a year with a 2.91% annual three-factor alpha. Other strategies such as low-priced earnings and low book to market returned 15.23% and 15.03% over the period studied.
The process used to calculate TEV and EBITDA in this study is broadly similar to the method used for these ratios in general. EBITDA is calculated by adding operating income before depreciation and non-operating income. Total enterprise value is calculated by adding market capitalization, short-term debt, long-term debt and preferred stock and then subtracting cash and short-term investments.
The authors of the study also take a look at how long-term valuation metrics can help to value equities. Long-term valuation metrics are defined as current multiples based on several years of earnings such as the five-year price-earnings (P/E) ratio. For example, using the EBITDA/TEV multiple taken over eight years produced an annual return of 16.49% over the four-decade study with an annual rebalancing. As well as the EBITDA/TEV metric, the FCF/TEV ratio also appears to add value with a backtested return of 16.57% per annum observed.
Not only do the EBITDA and FCF strategies appear to have a better long-term performance than all other metrics, but the strategies also seem to be able to achieve this performance with lower than average volatility. A drawdown analysis for EBITDA and FCF shows these stock portfolios see maximum drawdowns that are considerably smaller than those of other portfolios.
The bottom line
Overall, it appears there is one valuation metric that has more weight than others when it comes to valuing stocks. The EBITDA/TEV ratio shows outperformance over the past four decades. Stocks that are cheap on this metric have produced returns of nearly 18% per annum according to the study mentioned above.
Of course, as with all backtested studies, it remains to be seen if this performance can continue going forward. But with four decades of data supporting the conclusion it does outperform over the long term, it makes sense to include the EBITDA/TEV multiple in your investing strategy, either as a standalone metric in a quantitative strategy or a part of a qualitative valuation process.
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