Business

What is the Best Valuation Metric? 26 Years of Data Points to One

As a dyed wool value investor, I believe that value will outperform growth or other strategies on a long term basis. There are various ways of valuing stocks using quantitive metrics. Bank of America Merrill Lynch has just published an extremely fascinating report, which evaluates the best performing value strategies of 2012.

First a brief summary of the conclusion of BAML, followed by some in-depth analysis and charts.

Low Price to Book saw a 17.1% return this year, but Low EV/EBITDA gained just 3.7%, and is among the worst strategies in the year to date. A sector bias may be causing the divergence, and Low Price to Book Value stocks may have been helped by a strong performance of the Financials sector (+16.1% YTD), which currently accounts for 62% of the factor’s weight. EV/EBITDA’s largest sector concentration is in Energy (34%), one of the weakest performing S&P 500 sectors this year (+2.5%).

According to one study we posted late last year, EV/EBITDA is the best valuation metric. The study states that EV/EBITDA has historically outperformed price over free cash flow, price over book, price over earnings, and other common metrics. However, as the report notes, the weighting of energy might have reduced the returns. Futhermore, no metric will ever outperform the market every year.

The fascinating part about the report is that although Wall Street mostly focuses on short term performance, we have some valuation metrics going back to 1989.

Let us look at the  following six strategies; forward earnings yield, earnings yield, price over book value, price over free cash flow, price over sales, EV/EBITDA.

First a look at how the the metrics are calculated. The index used is the S&P 500

  • Earnings Yield: Trailing 12-month EPS divided by month-end price.
  • Forward Earnings Yield: Rolling 12-month Forward EPS divided by month-end price.
  • Price/Book Value: Month-end price divided by the most recently reported book value per share.
  • Price/Free Cash Flow: Month-end price divided by most recently reported free cash flow. Free Cash flow is defined as earnings post extraordinary items, plus depreciation, and minus capital expenditures.
  • Price/Sales: Month-end market value divided by most recently reported sales.
  • EV/EBITDA: Enterprise Value (Equity Market Capitalization + Long Term Debt + Short Term Debt + Preferred Stock + Minority Interest – Cash & Cash Equivalents) divided by EBITDA (Reported Net Income + Special Items – Minority Interest + Interest Expense + Income Tax Expense + Depreciation and Amortization) – most recently reported.
Stocks with a high earnings yield have done relatively well. This is not surprising, since earnings yield is the opposite of the price earnings ratio. Below is a chart with the returns from 1986/89-2012
What is the Best Valuation Metric? 26 Years of Data Points to One
The 50 S&P 500 (INDEX.INX) stocks with the highest earnings yield are listed below (note: the ones listed throughout the article are not necessarily in any particular order).

Ford Motor Company (NYSE:F) 49%

Staples, Inc. (NASDAQ:SPLS) 12.18%

American International Group, Inc. (NYSE:AIG) 33.09%

Corning Incorporated (NYSE:GLW) 12.09%

Cliffs Natural Resources Inc (NYSE:CLF) 28.04%

Chevron Corporation (NYSE:CVX) 12.06%

Seagate Technology PLC (NASDAQ:STX) 20.99%

Bank of America Corp (NYSE:BAC) 12.02%

Metlife Inc (NYSE:MET)18.58%

Citigroup Inc. (NYSE:C) 11.95%

Assurant, Inc. (NYSE:AIZ)18.04%

AFLAC INC. DL -,10 (FRA:AFL) 11.89% 46.18

Chesapeake Energy Corporation (NYSE:CHK) 17.52%

Northrop Grumman Corporation (NYSE:NOC) 11.86%

New Phillips 66 (NYSE:PSX) 16.90%

Tesoro Corporation (NYSE:TSO) 11.85%

Dell Inc. (NASDAQ:DELL)16.05% 10.59

Safeway Inc. (NYSE:SWY) 11.76%

Western Digital Corp. (NASDAQ:WDC)16.00%

JPMorgan Chase & Co. (NYSE:JPM) 11.66%

Peabody Energy Corporation (NYSE:BTU) 15.67%

Teradyne, Inc. (NYSE:TER)11.65% 15.62

Apollo Group Inc (NASDAQ:APOL)15.53%

Gannett Co., Inc. (NYSE:GCI) 11.21% 15.26

Pitney Bowes Inc. (NYSE:PBI) 14.97% 13.36 16

Discover Financial Services (NYSE:DFS) 11.15%

Lexmark International Inc (NYSE:LXK)14.88%

The Allstate Corporation (NYSE:ALL) 11.13%

D.R. Horton, Inc. (NYSE:DHI) 14.80%

HELMERICH PAYNE  (NYSE:HP) 11.11%

Marathon Petroleum Corp (NYSE:MPC) 13.64%

The Western Union Company (NYSE:WU) 11.07%

Aetna Inc. (NYSE:AET) 13.46%

DeVry Inc. (NYSE:DV) 10.93%

Newfield Exploration Co. (NYSE:NFX) 13.39%

Exxon Mobil Corporation (NYSE:XOM), 10.89%

Joy Global Inc. (NYSE:JOY)13.28% 53.38 3

Humana Inc. (NYSE:HUM) 10.89% 70.08

L-3 Communications Holdings, Inc. (NYSE:LLL) 13.04%

Interpublic Group of Companies, Inc. (NYSE:IPG) 10.81%

CF Industries Holdings, Inc. (NYSE:CF) 12.80%

Denbury Resources Inc. (NYSE:DNR) 10.78% 15.49

New Prudential Financial Inc (NYSE:PRU) 12.71% 54.51

Caterpillar Inc. (NYSE:CAT) 10.77%

Xerox Corporation (NYSE:XRX) 12.48%

Fifth Third Bancorp (NASDAQ:FITB) 10.63%

GameStop Corp. (NYSE:GME) 12.47%

KeyCorp (NYSE:KEY) 10.56%

WellPoint, Inc. (NYSE:WLP) 12.39%

New SLM Corp (NASDAQ:SLM) 10.54%

Forward earnings yield has outperformed the market, but less than the other strategies shown below. My guess would be that the underperformance relative to other value strategies, is due to inaccurate forecasts of future earnings.

Price to book strategy has been a disappointment. However, the reason for the poor performance is likely due to a disproportionate weighting in the financial sector.

What is the Best Valuation Metric? 26 Years of Data Points to One

Below are the top 50 stocks in the S&P 500 (INDEX.INX) which have the lowest price over book value.

Genworth Financial Inc (NYSE:GNW) 0.16

The Bank of New York Mellon Corporation (NYSE:BK) 0.78

Alpha Natural Resources, Inc. (NYSE:ANR) 0.26

Micron Technology, Inc. (NASDAQ:MU) 0.79

 The Hartford Financial Services Grup Inc (NYSE:HIG) 0.36

 People’s United Financial, Inc. (NASDAQ:PBCT) 0.79

Bank of America Corp (NYSE:BAC) 0.40

United States Steel Corporation (NYSE:X)0.79

Lincoln National Corporation (NYSE:LNC) 0.46

Xerox Corporation (NYSE:XRX) 0.80

Citigroup Inc. (NYSE:C) 0.47

New Cliffs Natural Resources Inc (NYSE:CLF) 0.81

E TRADE Financial Corporation (NASDAQ:ETFC) 0.48

Hudson City Bancorp, Inc. (NASDAQ:HCBK) 0.81

Morgan Stanley (NYSE:MS) 0.48

KeyCorp (NYSE:KEY) 0.81

First Solar, Inc. (NASDAQ:FSLR) 0.52

Loews Corporation (NYSE:L) 0.82 40.65

WPX Energy Inc (NYSE:WPX)0.56

WellPoint, Inc. (NYSE:WLP) 0.82

American International Group, Inc. (NYSE:AIG) 0.57

CME Group Inc (NASDAQ:CME) 0.84

Assurant, Inc. (NYSE:AIZ) 0.58

Corning Incorporated (NYSE:GLW) 0.84

Metlife Inc (NYSE:MET) 0.58

Comerica Incorporated (NYSE:CMA) 0.85 30.71

LEGG M ASON IN C LM 0.61

GameStop Corp. (NYSE:GME) 0.85

NRG Energy Inc (NYSE:NRG)0.65 21.34

Leucadia National Corp. (NYSE:LUK) 0.86

Unum Group (NYSE:UNM) 0.65

Principal Financial Group Inc (NYSE:PFG) 0.86

Alcoa Inc. (NYSE:AA) 0.67

Hess Corp. (NYSE:HES) 0.87

Prudential Financial Inc (NYSE:PRU) 0.67

Capital One Financial Corp. (NYSE:COF) 0.88

SunTrust Banks, Inc. (NYSE:STI) 0.67

Chesapeake Energy Corporation (NYSE:CHK) 0.89

Regions Financial Corporation (NYSE:RF) 0.68

DeVry Inc. (NYSE:DV) 0.92 19.31

XL Group plc (NYSE:XL) 0.72

 The Allstate Corporation (NYSE:ALL) 0.93

Goldman Sachs Group, Inc. (NYSE:GS) 0.75

ACE Limited (NYSE:ACE) 0.97 73.73

Nabors Industries Ltd. (NYSE:NBR) 0.75

PNC Financial Services (NYSE:PNC) 0.97 62.16

Zions Bancorporation (NASDAQ:ZION) 0.76

New Sealed Air Corp (NYSE:SEE) 0.97

JPMorgan Chase & Co.(NYSE:JPM) 0.77

Southwest Airlines Co. (NYSE:LUV) 0.97

NASDAQ OMX Group, Inc. (NASDAQ:NDAQ) 0.77

New Tyson Foods, Inc. (NYSE:TSN) 0.97

Next comes Price over free cash flow, another popular metric. As shown below, the strategy seems to have done quite well.

50 stocks which meet the criteria of the lowest price over free cash flow:

Ford Motor Company (NYSE:F) 1.88

Tesoro Corporation (NYSE:TSO) 8.57

Netflix, Inc. (NASDAQ:NFLX) 2.46

KeyCorp (NYSE:KEY) 8.65

Pitney Bowes Inc. (NYSE:PBI) 3.35

Marathon Petroleum Corp (NYSE:MPC) 8.65

Seagate Technology PLC (NASDAQ:STX)4.51

Symantec Corporation (NASDAQ:SYMC) 8.72

Xerox Corporation (NYSE:XRX) 4.54

WellPoint, Inc. (NYSE:WLP) 8.77

Lexmark International Inc (NYSE:LXK) 5.30

Citigroup Inc. (NYSE:C) 8.97

DELL INC DELL 5.54

Discover Financial Services (NYSE:DFS) 9.07

Apollo Group Inc (NASDAQ:APOL) 5.92

General Dynamics Corporation (NYSE:GD) 9.07

Western Digital Corp. (NASDAQ:WDC) 5.95

Interpublic Group of Companies, Inc. (NYSE:IPG) 9.11

Cliffs Natural Resources Inc (NYSE:CLF) 6.80

Fidelity National Information Services (NYSE:FIS) 9.38

Frontier Communications Corp (NASDAQ:FTR) 6.82

Whirlpool Corporation (NYSE:WHR) 9.39

D.R. Horton, Inc. (NYSE:DHI) 6.84

Raytheon Company (NYSE:RTN) 9.41

Gannett Co., Inc. (NYSE:GCI) 6.99

Parker-Hannifin Corporation (NYSE:PH) 9.67

Aetna Inc. (NYSE:AET) 7.14

Harman International Industries Inc./DE/ (NYSE:HAR) 9.70

GameStop Corp. (NYSE:GME) 7.23

CA, Inc. (NASDAQ:CA) 9.75

Staples, Inc. (NASDAQ:SPLS) 7.23

Humana Inc. (NYSE:HUM) 9.89

L-3 Communications Holdings, Inc. (NYSE:LLL) 7.31

Macy’s, Inc. (NYSE:M) 9.90

CF Industries Holdings, Inc. (NYSE:CF) 7.31

Safeway Inc. (NYSE:SWY) 10.04

CenterPoint Energy, Inc. (NYSE:CNP) 7.74

The Bank of New York Mellon Corporation (NYSE:BK) 10.06

R.R. Donnelley & Sons Company (NASDAQ:RRD) 7.89

Peabody Energy Corporation (NYSE:BTU) 10.15

The Western Union Company (NYSE:WU) 7.91

CIGNA Corporation (NYSE:CI) 10.31

Huntington Bancshares Incorporated (NASDAQ:HBAN) 8.09

Zions Bancorporation (NASDAQ:ZION) 10.32

Northrop Grumman Corporation (NYSE:NOC) 8.16

UnitedHealth Group Inc. (NYSE:UNH) 10.44

Teradyne, Inc. (NYSE:TER) 8.23

CenturyLink, Inc. (NYSE:CTL) 10.45

Joy Global Inc. (NYSE:JOY) 8.49

Lockheed Martin Corporation (NYSE:LMT)10.49

Low price to sales stocks, have been another great performer, as seen in the chart below:

The top 50 S&P 500 stocks which meet the low price to sales criteria are listed below:

Sears Holdings Corporation (NASDAQ:SHLD) 0.05

Wal-Mart Stores, Inc. (NYSE:WMT) 0.27

Safeway Inc. (NYSE:SWY) 0.9

Hewlett-Packard Company (NYSE:HPQ) 0.27

Sunoco, Inc. (NYSE:SUN) 0.11

GameStop Corp. (NYSE:GME) 0.27

AutoNation, Inc. (NYSE:AN) 0.11

SAIC, Inc. (NYSE:SAI) 0.30

AmerisourceBergen Corp. (NYSE:ABC) 0.12

Humana Inc. (NYSE:HUM) 0.30

Valero Energy Corporation (NYSE:VLO) 0.13

Staples, Inc. (NASDAQ:SPLS) 0.31

Cardinal Health, Inc. (NYSE:CAH) 0.13

Computer Sciences Corporation (NYSE:CSC) 0.31

The Goodyear Tire & Rubber Company (NYSE:GT) 0.13 1

Whirlpool Corporation (NYSE:WHR) 0.32

Tyson Foods, Inc. (NYSE:TSN) 0.14

WellPoint, Inc. (NYSE:WLP) 0.32

The Kroger Co. (NYSE:KR) 0.14

Ryder System, Inc. (NYSE:R)0.33

United States Steel Corporation (NYSE:X) 0.14

Fluor Corporation (NEW) (NYSE:FLR) 0.34

Phillips 66 (NYSE:PSX) 0.15

Assurant, Inc. (NYSE:AIZ) 0.34

Alpha Natural Resources, Inc. (NYSE:ANR) 0.16

Advanced Micro Devices, Inc. (NYSE:AMD) 0.34 3.72

161 McKesson Corporation (NYSE:MCK) 0.17

Murphy Oil Corporation (NYSE:MUR) 0.35

Tesoro Corporation (NYSE:TSO) 0.18

The Hartford Financial Services Grup Inc (NYSE:HIG) 0.36

R.R. Donnelley & Sons Company (NASDAQ:RRD) 0.19

Big Lots, Inc. (NYSE:BIG) 0.37

Archer Daniels Midland Company (NYSE:ADM) 0.20

 Alcoa Inc. (NYSE:AA) 0.37

Dean Foods Company (NYSE:DF) 0.23

First Solar, Inc. (NASDAQ:FSLR) 0.38

 Marathon Petroleum Corp (NYSE:MPC) 0.23

Aetna Inc. (NYSE:AET) 0.38

Tenet Healthcare Corporation (NYSE:THC) 0.24

SEALED AIR CORP SEE 0.38

Jabil Circuit, Inc. (NYSE:JBL) 0.24

Lexmark International Inc (NYSE:LXK) 0.38

J.C. Penney Company, Inc.(NYSE:JCP) 0.24

American International Group, Inc.(NYSE:AIG ) 0.39

Genworth Financial Inc (NYSE:GNW) 0.26

Owens-Illinois, Inc. (NYSE:OI) 0.40

Dell Inc. (NASDAQ:DELL) 0.26

Southwest Airlines Co. (NYSE:LUV) 0.40

Ford Motor Company (NYSE:F) 0.27

Hess Corp. (NYSE:HES) 0.41 50.53

Finally, EV/EBITDA, which the study concludes is, as well, one of the best performing metrics.

What is the Best Valuation Metric? 26 Years of Data Points to One

The 50 stocks in the S&P 500 which have the lowest EV/EBITDA are listed below:

New Humana Inc. (NYSE:HUM) 0.49

CF Industries Holdings, Inc. (NYSE:CF) 3.81

First Solar, Inc. (NASDAQ:FSLR) 1.77

Advanced Micro Devices, Inc. (NYSE:AMD) 3.81

Lexmark International Inc (NYSE:LXK) 1.89

 Tyson Foods, Inc. (NYSE:TSN) 3.87

Netflix, Inc. (NASDAQ:NFLX)1.94

Corning Incorporated (NYSE:GLW) 3.87

WellPoint, Inc. (NYSE:WLP) 2.04

Aetna Inc. (NYSE:AET) 3.91

Apollo Group Inc (NASDAQ:APOL) 2.08

The Goodyear Tire & Rubber Company (NYSE:GT) 3.97 1

Murphy Oil Corporation (NYSE:MUR) 2.66

Time Warner Inc. (NYSE:TWX) 4.01

DeVry Inc. (NYSE:DV) 2.70 19.31

Sunoco, Inc. (NYSE:SUN) 4.02

GameStop Corp. (NYSE:GME) 2.81

Hess Corp. (NYSE:HES) 4.03

Dell Inc. (NASDAQ:DELL) 2.86

Helmerich & Payne, Inc. (NYSE:HP) 4.07

Alpha Natural Resources, Inc. (NYSE:ANR)  2.91

Devon Energy Corporation (NYSE:DVN) 4.10

Western Digital Corp. (NASDAQ:WDC) 3.16

Valero Energy Corporation (NYSE:VLO) 4.10

Marathon Oil Corporation (NYSE:MRO) 3.25

COMCAST C ORP CMCSA 4.17

Molex Incorporated (NASDAQ:MOLX) 3.31

Staples, Inc. (NASDAQ:SPLS) 4.18

Seagate Technology PLC (NASDAQ:STX) 3.39

R.R. Donnelley & Sons Company (NASDAQ:RRD) 4.26

Best Buy Co., Inc. (NYSE:BBY) 3.41

MetroPCS Communications Inc (NYSE:PCS) 4.27

Chevron Corporation (NYSE:CVX) 3.41

Discovery Communications Inc. (NASDAQ:DISCA) 4.29

ConocoPhillips (NYSE:COP) 3.42

QEP Resources Inc (NYSE:QEP) 4.33

Apache Corporation (NYSE:APA) 3.43

H&R Block, Inc. (NYSE:HRB) 4.34

Viacom, Inc. (NASDAQ:VIAB) 3.45

Freeport-McMoRan Copper & Gold Inc. (NYSE:FCX) 4.48

Newfield Exploration Co. (NYSE:NFX) 3.64

Cliffs Natural Resources Inc (NYSE:CLF)4.56

Tesoro Corporation (NYSE:TSO) 3.66

Exxon Mobil Corporation (NYSE:XOM) 4.56

The Washington Post Company (NYSE:WPO) 3.76

Nabors Industries Ltd. (NYSE:NBR)4.60

Marathon Petroleum Corp (NYSE:MPC) 3.79

Safeway Inc. (NYSE:SWY) 4.63

Computer Sciences Corporation (NYSE:CSC) 3.79

Gannett Co., Inc. (NYSE:GCI) 4.77 15.26

Takeaways:

According to the data from the charts, EV/EBITDA is by far the best performing valuation metric among the six sampled here. What is the reason that this metric is so accurate? According to the study mentioned earlier, the answer is not simple. The authors point out the problems with other metrics they used, such as price earnings ratio, price/market and FCF/EV. However, there is no definitative reason given as to why EV/EBITDA outperforms the other value metrics. The authors note that EV/EBIDTA produces higher risk adjusted returns. Additionally, EV/EBIT has very similiar results to EV/EBITDA.

Greenbackd has a fantastic article on the topic.  Here is a brief explanation on why EV/EBITDA is the king of value metrics.

In terms of the numerator, EV can be viewed as a theoretical takeover price of a firm. After a takeover, the acquirer assumes the debt of the firm, but gains use of the firm’s cash and cash equivalents. Including debt is important here. To take an example, in 2005, General Motors had a market cap of $17 billion, but a debt of $287 billion. Using market value of equity as a measure of size, General Motors is a mid-sized firm. Yet on the basis of Enterprise Value, GM is a huge company. Market value of equity, by itself, is unlikely to fully capture the effect GM’s debt has on its returns.

The denominator;  Damodaran notes that differences in depreciation methods across companies will affect net income, and hence BE, but not EBITDA. Also, the McKinsey valuation text notes that operating income is not affected by non-operating gains or losses. As a result, operating income before depreciation can be viewed as a more accurate and less manipulable measure of profitability, allowing it to be used to compare firms within, as well as across industries.

The enterprise multiple includes debt as well as equity, contains a clearer measure of operating profit, and captures changes in cash from period to period.

Two other good studies on this topic, which could be the topic of a future article (we are getting close to 2,000 words already!);The Enterprise Multiple Factor and the Value Premium and New Evidence on the Relation Between the Enterprise Multiple and Average Stock Returns/

Conclusion:

This is some very interesting data on how value metrics performed historically. Additionally, other ones not mentioned here, such as high share repurchases, did very well.  Many of the names which show up in the data are cyclical stocks, stocks in decline, and general value traps etc. There will be many stocks which underperform, however, as a basket, these stocks should do well over long periods of time, picking your favorite metric of the ones mentioned, especially EV/EBITDA. Unsurprisingly, many stocks appear on several lists. The reason being that stocks in unpopular sectors (which I would opine is now defence and the for profit education sector), have high earnings and are cheap on a quantitative basis.

Disclosure: Considering that 100s of stocks were listed above, I have positions in several of the stocks mentioned.