Friends, Romans, countrymen, lend me your ears;
I come to bury Caesar, not to praise him.
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):
Which price ratio outperforms the enterprise multiple? None. Vivat rex.