Posts Tagged ‘Enterprise Value’

Since Joel Greenblatt’s introduction of the Magic Formula in the 2006 book “The Little Book That Beats The Market,” researchers have conducted a number of studies on the strategy and found it to be a market beater, both domestically and abroad.

Greenblatt claims returns in the order of 30.8 percent per year against a market average of 12.3 percent, and S&P500 return of 12.4 percent per year:

In Does Joel Greenblatt’s Magic Formula Investing Have Any Alpha? Meena Krishnamsetty finds that the Magic Formula generates annual alpha 4.5 percent:

It doesn’t beat the index funds by 18% per year and generate Warren Buffett like returns, but the excess return is still more than 5% per year. This is better than Eugene Fama’s DFA Small Cap Value Fund. It is also better than Lakonishok’s LSV Value Equity Fund.

Wes Gray’s Empirical Finance Blog struggles to repeat the study:

[We] can’t replicate the results under a variety of methods.

We’ve hacked and slashed the data, dealt with survivor bias, point-in-time bias, erroneous data, and all the other standard techniques used in academic empirical asset pricing analysis–still no dice.

In the preliminary results presented below, we analyze a stock universe consisting of large-caps (defined as being larger than 80 percentile on the NYSE in a given year). We test a portfolio that is annually rebalanced on June 30th, equal-weight invested across 30 stocks on July 1st, and held until June 30th of the following year.

Wes finds “serious outperformance” but “nowhere near the 31% CAGR outlined in the book.

Wes thinks that the outperformance of the Magic Formula is due to small cap stocks, which he tests in a second post “Magic Formula and Small Caps–The Missing Link?

Here are Wes’s results:

[While] the MF returns are definitely higher when you allow for smaller stocks, the results still do not earn anywhere near 31% CAGR.

Some closer observations of our results versus the results from the book:

For major “up” years, it seems that our backtest of the magic formula are very similar (especially from a statistical standpoint where the portfolios only have 30 names): 1991, 1995, 1997, 1999, 2001, and 2003.

The BIG difference is during down years: 1990, 1994, 2000, and 2002. For some reason, our backtest shows results which are roughly in line with the R2K (Russell 2000), but the MF results from the book present compelling upside returns during market downturns–so somehow the book results have negative beta during market blowouts? Weird to say the least…

James Montier, in a 2006 paper, “The Little Note That Beats the Markets” says that it works globally:

The results of our backtest suggest that Greenblatt’s strategy isn’t unique to the US. We tested the Little Book strategy on US, European, UK and Japanese markets between 1993 and 2005. The results are impressive. The Little Book strategy beat the market (an equally weighted stock index) by 3.6%, 8.8%, 7.3% and 10.8% in the various regions respectively. And in all cases with lower volatility than the market! The outperformance was even better against the cap weighted indices.

So the Magic Formula generates alpha, and beats the market globally, but not by as much as Greenblatt found originally, and much of the outperformance may be due to small cap stocks.

The Magic Formula and EBIT/TEV

Last week I took a look at the Loughran Wellman and Gray Vogel papers that found the enterprise multiple,  EBITDA/enterprise value, to be the best performing price ratio. A footnote in the Gray and Vogel paper says that they conducted the same research substituting EBIT for EBITDA and found “nearly identical results,” which is perhaps a little surprising but not inconceivable because they are so similar.

EBIT/TEV is one of two components in the Magic Formula (the other being ROC). I have long believed that the quality metric (ROC) adds little to the performance of the value metric (EBIT/EV), and that much of the success of the Magic Formula is due to its use of the enterprise multiple. James Montier seems to agree. In 2006, Montier backtested the strategy and its components in the US, Europe ex UK, UK and Japan:

The universe utilised was a combination of the FTSE and MSCI indices. This gave us the largest sample of data. We analysed the data from 1993 until the end of 2005. All returns and prices were measured in dollars. Utilities and Financials were both excluded from the test, for reasons that will become obvious very shortly. We only rebalance yearly.

Here are the results of Montier’s backtest of the Magic Formula:

And here’re the results for EBIT/TEV over the same period:

Huh? EBIT/TEV alone outperforms the Magic Formula everywhere but Japan?

Montier says that return on capital seems to bring little to the party in the UK and the USA:

In all the regions except Japan, the returns are higher from simply using a pure [EBIT/TEV] filter than they are from using the Little Book strategy. In the US and the UK, the gains from a pure [EBIT/TEV] strategy are very sizeable. In Europe, a pure [EBIT/TEV] strategy doesn’t alter the results from the Little Book strategy very much, but it is more volatile than the Little Book strategy. In Japan, the returns are lower than the Little Book strategy, but so is the relative volatility.

Montier suggests that one reason for favoring the Magic Formula over “pure” EBIT/TEV is career defence. The backtest covers an unusual period in the markets when expensive stocks outperformed for an extended period of time.

The charts below suggest a reason why one might want to have some form of quality input into the basic value screen. The first chart shows the top and bottom ranked deciles by EBIT/EV for the US (although other countries tell a similar story). It clearly shows the impact of the bubble. For a number of years, during the bubble, stocks that were simply cheap were shunned as we all know.

However, the chart below shows the top and bottom deciles using the combined Little Book strategy again for the US. The bubble is again visible, but the ROC component of the screen prevented the massive underperformance that was seen with the pure value strategy. Of course, the resulting returns are lower, but a fund manager following this strategy is unlikely to have lost his job.

In the second chart, note that it took eight years for the value decile to catch up to the glamour decile. They were tough times for value investors.


The Magic Formula beats the market, and generates real alpha. It might not beat the market by as much as Greenblatt found originally, and much of the outperformance is due to small cap stocks, but it’s a useful strategy. Better performance may be found in the use of pure EBIT/EV, but investors employing such a strategy could have very long periods of lean years.

Buy my book The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market from on Kindlepaperback, and Audible.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on The Acquirer’s Multiple, or connect with me on Twitter, LinkedIn or Facebook. Check out the best deep value stocks in the largest 1000 names for free on the deep value stock screener at The Acquirer’s Multiple®.



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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.

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Which price ratio best identifies undervalued stocks? It’s a fraught question, dependent on various factors including the time period tested, and the market capitalization and industries under consideration, but I believe a consensus is emerging.

The academic favorite remains book value-to-market capitalization (the inverse of price-to-book value). Fama and French maintain that it makes no difference which “price-to-a-fundamental” is employed, but if forced to choose favor book-to-market. In the Fama/French Forum on Dimensional Fund Advisor’s website they give it a tepid thumbs up despite the evidence that it’s not so great:

Data from Ken French’s website shows that sorting stocks on E/P or CF/P data produces a bigger spread than BtM over the last 55 years. Wouldn’t it make sense to use these other factors in addition to BtM to distinguish value from growth stocks? EFF/KRF: A stock’s price is just the present value of its expected future dividends, with the expected dividends discounted with the expected stock return (roughly speaking). A higher expected return implies a lower price. We always emphasize that different price ratios are just different ways to scale a stock’s price with a fundamental, to extract the information in the cross-section of stock prices about expected returns. One fundamental (book value, earnings, or cashflow) is pretty much as good as another for this job, and the average return spreads produced by different ratios are similar to and, in statistical terms, indistinguishable from one another. We like BtM because the book value in the numerator is more stable over time than earnings or cashflow, which is important for keeping turnover down in a value portfolio. Nevertheless, there are problems in all accounting variables and book value is no exception, so supplementing BtM with other ratios can in principal improve the information about expected returns. We periodically test this proposition, so far without much success.

There are a variety of papers on the utility of book value that I’ve beaten to death on Greenbackd. I used to think it was the duck’s knees because that was what all the early research seemed to say (See, for example, Roger Ibbotson’s “Decile Portfolios of the New York Stock Exchange, 1967 – 1984,” Werner F.M. DeBondt and Richard H. Thaler’s “Further Evidence on Investor Overreaction and Stock Market Seasonality”). Josef Lakonishok, Andrei Shleifer, and Robert Vishny’s Contrarian Investment, Extrapolation and Risk, which was updated by The Brandes Institute as Value vs Glamour: A Global Phenomenon reopened the debate, suggesting that price-to-earnings and price-to-cash flow might add something to price-to-book.

A number of more recent papers have moved away from book-to-market, and towards the enterprise multiple ((equity value + debt + preferred stock – cash)/ (EBITDA)). As far as I am aware, Tim Loughran and Jay W. Wellman got in first with their 2009 paper “The Enterprise Multiple Factor and the Value Premium,” which was a great unpublished paper, but became in 2010 a slightly less great published paper, “New Evidence on the Relation Between the Enterprise Multiple and Average Stock Returns,” suitable only for academics and masochists (but I repeat myself). The abstract to the 2009 paper (missing from the 2010 paper) cuts right to the chase:

Following the work of Fama and French (1992, 1993), there has been wide-spread usage of book-to-market as a factor to explain stock return patterns. In this paper, we highlight serious flaws with the use of book-to-market and offer a replacement factor for it. The Enterprise Multiple, calculated as (equity value + debt value + preferred stock – cash)/ EBITDA, is better than book-to-market in cross-sectional monthly regressions over 1963-2008. In the top three size quintiles (accounting for about 94% of total market value), EM is a highly significant measure of relative value, whereas book-to-market is insignificant.

The abstract says everything you need to know: Book-to-market is widely used (by academics), but it has serious flaws. The enterprise multiple is more predictive over a long period (1963 to 2008), and it’s much more predictive in big market capitalization stocks where book-to-market is essentially useless.

What serious flaws?

The big problem with book-to-market is that so much of the return is attributable to nano-cap stocks and “the January effect”:

Loughran (1997) examines the data used by Fama and French (1992) and finds that the results are driven by a January seasonal and the returns on microcap growth stocks. For the largest size quintile, accounting for about three-quarters of total market cap, Loughran finds that BE/ME has no significant explanatory power over 1963-1995. Furthermore, for the top three size quintiles, accounting for about 94% of total market cap, size and BE/ME are insignificant once January returns are removed. Fama and French (2006) confirm Loughran’s result over the post- 1963 period. Thus, for nearly the entire market value of largest stock market (the US) over the most important time period (post-1963), the value premium does not exist.

That last sentence bears repeating: For nearly the entire market value of largest stock market (the US) over the most important time period (post-1963), the value premium does not exist, which means that book-to-market is not predictive in stocks other than the smallest 6 percent by market cap. What about book-to-market in the stocks in that smallest 6 percent? It might not work there either:

Keim (1983) shows that the January effect is primarily limited to the first trading days in January. These returns are heavily influenced by December tax-loss selling and bid-ask bounce in low-priced stocks. Since many fund managers are restricted in their ability to buy small stocks due to ownership concentration restrictions and are prohibited from buying low-prices stocks due to their speculative nature, it is unlikely that the value premium can be exploited.

More scalable

The enterprise multiple succeeds where book-to-market fails.

In the top three size quintiles, accounting for about 94% of total market value, EM is a highly significant measure of relative value, whereas BE/ME is insignificant and size is only weakly significant. EM is also highly significant after controlling for the January seasonal and removing low-priced (<$5) stocks. Robustness checks indicate that EM is also better to Tobin’s Q as a determinant of stock returns.

And maybe the best line in the  paper:

Our results are an improvement over the existing literature because, rather than being driven by obscure artifacts of the data, namely the stocks in the bottom 6% of market cap and the January effect, our results apply to virtually the entire universe of US stocks. In other words, our results may actually be relevant to both Wall Street and academics.

Why does the enterprise multiple work?

The enterprise multiple is a popular measure, and for other good reasons besides its performance. First, the enterprise multiple uses enterprise value. A stock’s enterprise value provides more information about its true cost than its market capitalization because it includes information about the stock’s balance sheet, including its debt, cash and preferred stock (and in some variations minorities and net payables-to-receivables). Such things are significant to acquirers of the business in its entirety, which, after all, is the way that value investors should think about each stock. Market capitalization can be misleading. Just because a stock is cheap on a book value basis does not mean that it’s cheap 0nce its debt load is factored into the valuation. Loughran and Wellman, quoting Damodaran (whose recent paper I covered here last week), write:

Damodaran shows in an unpublished study of 550 equity research reports that EM, along with Price/Earnings and Price/Sales, were the most common relative valuation multiples used. He states, “In the past two decades, this multiple (EM) has acquired a number of adherents among analysts for a number of reasons.” The reasons Damodaran cites for EM’s increasing popularity also point to the potential superiority of EM over book-to-market. One reason is that EM can be compared more easily across firms with differing leverage. We can see this when comparing the corresponding inputs of EM and BE/ME. The numerator of EM, Enterprise Value, can be compared to the market value of equity. 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 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. More generally, it is reasonable to think that changing firm debt levels may affect returns in a way not fully captured by market value of equity. Bhojraj and Lee (2002) confirm this, finding that EV is superior to market value of common equity, particularly when firms are differentially levered.

The enterprise multiple’s ardor for cash and abhorrence for debt matches my own, hence why I like it so much. In practice, that tendency can be a double-edged sword. It digs up lots of little cash boxes with a legacy business attached like an appendix (think Daily Journal Corporation (NASDAQ:DJCO) or Rimage Corporation (NASDAQ:RIMG)). Such stocks tend to have limited upside. On the flip side, they also have happily virtually no downside. In this way they are vastly superior to the highly leveraged pigs favored by book-to-market, which tends to serve up heavily leveraged slivers of somewhat discounted equity, and leaves you to figure out whether it can bear the debt load. Get it wrong and you’ll be learning the intricacies of the bankruptcy process with nothing to show for it at the end. When it comes time to pull the trigger, I generally find it easier to do it with a cheap enterprise multiple than a cheap price-to-book value ratio.

The earnings variable: EBITDA

There’s a second good reason to like the enterprise multiple: the earnings variable. EBITDA contains more information than straight earnings, and so should give a more full view of where the accounting profits flow:

The denominator of EM is operating income before depreciation while net income (less dividends) flows into BE. The use of EBITDA provides several advantages that BE lacks. 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 nonoperating 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. Critics of EBITDA point out that it is not a substitute for cash flow; however, EV in the numerator does account for cash.

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. The enterprise multiple is a more complete measure of relative value than book-to-market. It also performs better:

Performance of the enterprise multiple versus book-to-market

From CXOAdvisory:

  • EM generates an annual value premium of 5.8% per year over the entire sample period (compared to 4.8% for B/M during 1926-2004).
  • EM captures more premium than B/M for all five quintiles of firm size and is much less dependent on small stocks for its overall premium (see chart below).
  • In the top three quintiles of firm size (accounting for about 94% of total market capitalization), EM is a highly significant measure of relative value, while B/M is not.
  • EM remains highly significant after controlling for the January effect and after removing low-priced (<$5) stocks.
  • EM outperforms Tobin’s q as a predictor of stock returns.
  • Evidence from the UK and Japan confirms that EM is a highly significant measure of relative value.

The “value premium” is the difference in returns to a portfolio of glamour stocks (i.e., the most expensive decile) when compared to a portfolio of value stocks (i.e., the cheapest decile) ranked on a given price ratio (in this case, the enterprise multiple and book-to-market). The bigger the value premium, the better a given price ratio sorts stocks into winners and losers. It’s a more robust test than simply measuring the performance of the cheapest stocks. Not only do we want to limit our sins of commission (i.e., buying losers), we want to limit our sins of omission (i.e., not buying winners). 

Here are the value premia by market capitalization (from CXOAdvisory again): Ring the bell. The enterprise multiple kicks book-to-market’s ass up and down in every weight class, but most convincingly in the biggest stocks.

Strategies using the enterprise multiple

The enterprise multiple forms the basis for several strategies. It is the price ratio limb of Joel Greenblatt’s Magic Formula. It also forms the basis for the Darwin’s Darlings strategy that I love (see Hunting Endangered Species). The Darwin’s Darlings strategy sought to front-run the LBO firms in the early 2000s, hence the enterprise multiple was the logical tool, and highly effective.


This post was motivated by the series last week on Aswath Damodaran’s paper ”Value Investing: Investing for Grown Ups?” in which he asks, “If value investing works, why do value investors underperform?Loughran and Wellman also asked why, if Fama and French (2006) find a value premium (measured by book-to-market) of 4.8% per year over 1926-2004, mutual fund managers couldn’t capture it:

Fund managers perennially underperform growth indices like the Standard and Poor’s 500 Index and value fund managers do not outperform growth fund managers. Either the value premium does not actually exist, or it does not exist in a way that can be exploited by fund managers and other investors.

Loughran and Wellman find that for nearly the entire market value of largest stock market (the US) over the most important time period (post-1963), the value premium does not exist, which means that book-to-market is not predictive in stocks other than the smallest 6 percent by market cap (and even there the returns are suspect). The enterprise multiple succeeds where book-to-market fails. In the top three size quintiles, accounting for about 94% of total market value, the enterprise multiple is a highly predictive measure, while book-to-market is insignificant. The enterprise multiple also works after controlling for the January seasonal effect and after removing low priced (<$5) stocks. The enterprise multiple is king. Long live the enterprise multiple.

Buy my book The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market from on Kindlepaperback, and Audible.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on The Acquirer’s Multiple, or connect with me on Twitter, LinkedIn or Facebook. Check out the best deep value stocks in the largest 1000 names for free on the deep value stock screener at The Acquirer’s Multiple®.

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