Digging into the Enterprise Multiple Factor

Digging into the Enterprise Multiple Factor

October 23, 2014 Research Insights, Value Investing Research
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(Last Updated On: January 18, 2017)

New Evidence on the Relation Between the Enterprise Multiple and Average Stock Returns

  • Loughran and Wellman
  • A version of the paper can be found here. (Also described in a much more entertaining fashion in Toby’s new book: Deep Value)
  • Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.


Practitioners increasingly use the enterprise multiple as a valuation measure. The enterprise multiple is (equity value debt preferred stock – cash)/ (EBITDA). We document that the enterprise multiple is a strong determinant of stock returns. Following Fama and French (1993) and Chen, Novy-Marx, and Zhang (2010), we create an enterprise multiple factor that generates a return premium of 5.28% per year. We interpret 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.

Core Idea:

Tests the effectiveness of enterprise multiples.

  • Enterprise value = market value of equity + debt + preferred stock – cash and short-term investments
  • Enterprise Multiple (EM) = EV/EBITDA

Alpha Highlight:

  1. Using Enterprise Multiples as a screening tool works, as those with low EM outperform those with high EM.
2014-10-03 17_39_51-0Value Reseach Recap.pptx - Microsoft PowerPoint (Product Activation Failed)
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Their explanation for why it works: “What drives the enterprise multiple effect in stock returns? We interpret the enterprise multiple as a proxy for the unlevered investment return (i.e., the weighted average cost of capital), which is in turn positively related to the firm’s cost of equity. Firms with high enterprise multiple values (signaling high valuation ratios) appear to have lower discount rates and lower subsequent realized stock returns than firms with low EM values.”

Our research yields similar results.

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.

  • DavidR

    Can you comment on EV/EBITDA which your journal article says is best, vs EV/EBIT, which you favor in your book?

  • EBIT/TEV is a marginal improvement, at least historically…

  • dan

    What are your thoughts on how to handle negative values? Since either EBIT or EV can be negative it can be a little tricky. I suppose if you invert and use EBIT/EV you could allow negative EBIT companies and have it ordinally line up how you like. If you eliminate negative EV companies, I believe I’ve seen that negative EV (which may imply lots of cash) can be a decent factor, although infrequent, so do you lose something by excluding negative EV companies? thanks in advance

  • we do a lot of things to make sure data is robust.

    For this situation if ev is negative and ebit is negative you get huge +, which jacks up the intent of the screen at some level. We just eliminate all negative ev situations.

    We’ve did that study a few years ago:

    I’m not a fan. I think these firms add a lot of noise, but not a lot of signal. There are plenty of fish in the sea without adding in the negative ev fish…

  • DavidR

    Any opinion why that might be?

  • noise, probably.

  • dan

    thanks. Just to be clear I think you’re saying negative EBIT companies are included. Correct?

  • deleted in our work. In this specific work they delete all kinds of things. Check out pg 8 in the paper

  • Michael Milburn

    Wes, I was re-looking through the tables in your book of various valuation multiples, and my thoughts kept drifting over to Gross Profit/EV ratio. While GP/EV didn’t win the race in the deepest value decile, it seemed to be better at broadly segmenting value over a wider range – especially excelling at segmenting the worst performers (deciles 1-3); and on the top end the top 3 deciles (8-10) all performed well. The spreads for deciles 8-10 were consistently wide also. (pgs 136-137). If we were to break the market into thirds it seems GP/EV might be the best performer in that regard.

    I guess I wonder if you had thoughts on this, and whether the consistency of GP/EV counts for much – or why EBIT/EV and EBITDA/EV seem to win at the extreme decile, but performance is not a consistently broad?

    thanks for your thoughts.

  • Michael Milburn

    also, are the papers that were listed at the turnkey analyst site still around somewhere? I’m trying to find something empirical on impact of earnings estimate revisions. thx

  • try a search for various items. We’ve written about just about everything at this point.

  • gp/ev is good. frankly, buying cheap stocks based on any metric seems to be useful.
    When one looks to international markets gp doesn’t seem to maintain its mojo–ebit/tev does…this suggests a robustness issue with gp/ev.

  • Paul Novell

    Good stuff. Supported by O’Shaugnessy’s work as well.

  • How much excess return do you expect QVAL to produce annually over the Value stock portfolio (“High book-to-market quintile, market-weighted returns” in the Ken French dataset) that you site in figures 8,9,10,11 of your white paper? The dataset must include many 100’s of stocks and QVAL has 50 ….

  • Hard to say. That said, we embrace tracking error when the risk/reward trade-off is favorable.

  • Denys Glushkov

    EV/EBITDA used to be a nice signal, especially when neutralized with respect to size, market (beta), volatility and industry exposures prior to portfolio formation. The main issue with it is that it did not really work in the last 5 years, with long-short strategy using Russell 3000 as universe making just under 3% total cumulative return since Sep 2009. Free Cash Flow/Price appears to be doing much better as a valuation metric, especially during the last 5 years with 85% cumulative total return of Long-Short portfolio since Sep 2009. EV/EBITDA did particularly during the value rebound in Q2/2009 peaking in Nov 2009, but has been rather flat and even declining since then. So it appears that people have been trading away inefficiencies associated with this signal as some other value signals did much better during last 5 years.

  • Great stuff and thanks for sharing.

    Just curious, what do the long-only stats look like? You have stats on good old fashioned CAGR, std.dev. and drawdown?

    Sometimes the “neutralized” ‘market neutral’ returns introduce a lot of noise into the comparison if the beta estimation occurs during the 2008 crisis when things are wild.

  • Denys Glushkov

    Wes, the long side is not much different. Neutralized EV/EBITDA during the last 5 years earned total return of 124% vs Russell 3000’s 113.4%, whereas Free Cash Flow/Price delivered 161.3% (while Net Operating CF/Price was at 159.1%). These are returns of signal-weighted long-only portfolios (value-weighted top quintile long-only produce similar relative ranking). Long-only tracking error and max drawdown of FCF/P (14.2% and 65.6%, respectively) are definitely larger than those of EV/EBITDA (21.1% and 56%), but higher information coefficient of FCF/P more than compensates for the risks (2% for FCF/P with t-stat of >5.00 vs. 0.9% for EV/EBITDA with tstat of 2.8). Despite greater risks, active return/active risk trade-off is much more favorable for FCF/P. As a matter of fact, most other value-oriented signals such as Div/P, Gross Profit Margin/Price, R&D/Price, Sale/Price all do better on the long side (and long-short side) than EV/EBITDA.

    Of course, past performance is no guarantee of future performance, but all it says that dominance of EV/EBITDA over other valuation is not as clear-cut as it might appear.

    As far as the noise induced by neutralization is concerned, neutralization actually helps, because it uses rolling betas, which helps keep quant portfolio well-balanced in terms of market exposure on the long and short sides and thereby, helps lower the vol. It also helps assess the pure alpha unrelated to other factors shown to explain returns.

  • Denys Glushkov

    sorry, tracking error of EV/EBITDA is 10.6%, not 21.1%.

  • Hey Denys,
    Just got back from nyc late last night. It is certainly the case that EBIT/TEV is NOT the best metric over every single 5 year rolling period. But it seems to be the best over the long-haul. In the end, the main point is to buy cheap–regardless of what metric you identify as your ‘favorite.’
    Understand your point on neutralization, but like to keep discussion on the blog accessible to non-phd quant geeks 🙂

  • Denys Glushkov

    understood:) …i would be curious if you were to take a simple equal-weighted mean of a number of valuation signals (say, average of the ones i mentioned earlier) and use that as a unified metric…my guess would be that it might do better than any single metric on its own. Maybe, you can use it in QVAL interacted with some quality signals such as accruals or net operating assets or asset growth…:)

  • composite signals are definitely interesting. can’t really discuss QVAL on our advisor website. Sorry about that.