Enterprise Value to EBITDA Ratio Backtest
The EBITDA to enterprise value (EV) ratio is a widely used valuation multiple to assess the relative value of companies. It is calculated by simply taking earnings before interest, taxes, depreciation and amortization (EBITDA) and dividing by enterprise value (EV). Of course, you need to know the definitions of both of those terms to really be able to understand this stock fundamental.
EBITDA is equal to net income with interest, taxes, depreciation, and amortization added back into it. EBITDA is somewhat useful for analyzing and comparing profitability between companies and industries because it removes differences due to tax rates and eliminates the effects of financing and accounting decisions. However, many value investors shun this fundamental due to its past abuse during the tech bubble. Charlie Munger is quoted as saying, “I think that, every time you saw the word EBITDA [earnings], you should substitute the word “bullshit” earnings.”
Enterprise Value takes into account the entire value of a company. It is equal to market capitalization plus debt minority interest and preferred shares, minus total cash and cash equivalents. However, for this backtest I simplified the formula similarly to the way Richard Tortoriello did in Quantitative Strategies for Achieving Alpha and just used market cap plus debt minus cash.
An advantage of the EV/EBITDA multiple is that it is capital structure-neutral, and, therefore, this multiple can be used for direct cross-companies application. The reciprocate multiple EBITDA/EV is used as a measure of cash return on investment. Given that EBITDA ignores capital structure by excluding interest and EV doesn’t discriminate between equity holders or debt holders, also accounting for the entire firm, this ratio provides a complete snapshot on the relative value of entire companies. You can use EV/EBITDA when you want to see the cash-generating power of the entire firm, and you don’t care whether it’s equity or debt financing this cash-generating operation. That’s why EV/EBITDA is used for pure valuation.
I used Portfolio123 to conduct a 10-year backtest of the EBITDA/EV ratio. I filtered out ADRs, non-US companies, companies in the miscellaneous financial services industry category (to mainly filter out closed-end funds), stocks trading below $2, market caps less than $433 million (approximately matching the average cut-off Tortoriello used), and companies that did not have a EBITDA/EV ratio due to missing data. The results are as follows:
Review the full Enterprise Value to EBITDA ratio backtest spreadsheet on Google Docs.
EV to EBITDA : Rolling 3-Yr Periods Excess Returns vs. Universe
As you can see from the table and charts above, stocks ranked in the highest 20% (1st quintile) of EBITDA/EV produced a CAGR of 11.37% from January 1, 2002 to December 31, 2011. Averaging the annual excess returns versus the universe using four different quarterly start dates, the average excess returns for the first quintile is 4.59%. That is very similar to the 5.3% Richard Tortoriello reported in Quantitative Strategies for Achieving Alpha for the period 1988-2007. Tortoriello found EV/EBITDA to be one of the most consistent (in terms of Sharpe Ratio) factors he tested. In the recent paper, Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years, Wesley Gray and Jack Vogel also found the EBITDA/EV ratio to have been the best performing metric historically. They found that it outperforms many investor favorites such as price-to-earnings, free-cash-flow to total enterprise value, and book-to-market.
Do you use the EV/EBITDA ratio? If not, why not given these results? What other fundamentals would you like to see backtest here? Please leave you responses in the comments section below.