The Enterprise Multiple and Expected Returns
Quantitative value investors have traditionally relied on price-to-book as the metric to classify stocks. But new research shows that price-to-enterprise value is a more powerful tool to construct portfolios. That research also sheds light on the question of whether the value premium is risk- or behaviorally-based.
Among the reasons investors have confidence in a value premium in equities are that it has been persistent across economic regimes; pervasive around the globe, industries and even asset classes; and robust to various definitions, including price-to-book, price-to-earnings, price-to-cash flow, price-to-sales and price-to-dividends. The research on the value premium was extended to the use of the enterprise multiple as the value metric by Tim Loughran and Jay Wellman in their 2010 study, “New Evidence on the Relation Between the Enterprise Multiple and Average Stock Returns.” The paper was published in the December 2011 issue of the Journal of Financial and Quantitative Analysis. Loughran and Wellman found that the enterprise multiple (equity + debt + preferred stock - cash) / (EBITDA) – earnings before interest, taxes, depreciation and amortization – is a strong determinant of stock returns, generating a return premium of 5.3% per year. They interpreted the enterprise multiple as a proxy for the discount rate. “Firms with low enterprise multiple values appear to have higher discount rates and higher subsequent stock returns than firms with high enterprise multiple values.”
Christian Walkshäusl and Sebastian Lobe extended the research on the enterprise multiple to international markets in their study “The Enterprise Multiple Investment Strategy: International Evidence,” which appeared in the August 2015 issue of the Journal of Financial and Quantitative Analysis. They found: “The enterprise multiple (EM) predicts the cross section of international returns. The return predictability of EM is similarly pronounced in developed and emerging markets and likewise strong among small and large firms. An international portfolio of low-EM firms outperforms a portfolio of high-EM firms by about 1% per month. The EM value premium is individually significant for the majority of countries, remains largely unexplained by existing asset pricing models, is robust after controlling for comovement with the respective U.S. premium, and is highly persistent for up to 5 years after portfolio formation, making it a promising strategy for investors.”