Return on Enterprise Value (ROEV) Backtest

Tuesday, January 24th, 2012 | Stock Fundamentals with 8 Comments

Return on Enterprise Value (ROEV) is a stock valuation ratio that can be useful for comparing the values of different companies. It is simply net cash flow divided by enterprise value. Net cash flow is net profit plus amounts charged off for depreciation, depletion, and amortization.

I was unfamiliar with this stock fundamental until Ken Faulkenberry of AAAMP Blog left the following comment on my Enterprise Value to EBITDA Ratio Backtest post:

Great post; glad to read someone uses this strategy in this day of “passive management”. This kind of valuation of stocks needs much more attention!

Personally I prefer Net Cash Flow / Enterprise Value which would include interest expense. I have written an article titled “Best Stock Valuation Calculation to Value Company Shares is ROEV” for anyone interested.

I decided to backtest Net Cash Flow / Enterprise value and compare it to the excellent results of the EV / EBITDA Ratio backtest.

I used StockScreen123 to conduct a 10-year backtest of the Return on Enterprise Value metric. 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, and companies that did not have a net cash flow/EV ratio due to missing data. The results are as follows:

Return on Enterprise Value: 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 Net Cash Flow / EV ratio produced a CAGR of 11.48% 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 4.80%. That is just slightly better than the 11.37% CAGR for EBITDA/EV 10-year backtest and the 4.59% average excess returns for the first quintile. The first quintile Sharpe and Sortino ratios for ROEV were almost identical to the EV/EBITDA backtest ratios. The ROEV strategy first quintile outperformed 85% of 1-year periods, while EV/EBITDA only outperformed 72.5% of 1-year periods. More impressively, the ROEV strategy outperformed 100% of rolling 3-year periods. Interestingly, looking at the lowest ranked stocks in the 5th quintile, ROEV averaged -5.29% excess returns versus the universe while EV/EBITDA averaged -5.84%. The bottom 20% of ROEV didn’t quite underperform as much as EV/EBITDA. Given how close the 1st quintile and 5th quintile scores are when comparing ROEV and EV/EBITDA, I’m not really sure you can say statistically that ROEV is better than EV/EBITDA. I really wish I could run a 20- or 30-year backtest on return on enterprise value. (Let us know if you can?)

Given these backtest results, I’m strongly considering working Return on Enterprise Value into my investment process, but it’s still difficult to tell if it is truly better than EBITDA/EV. What do you think? What other fundamentals would you like to see backtested here? Please leave you responses in the comments section below.

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Comments

  • Thank you George…you are doing an awesome service for your readers and investors in general!

    Ken Faulkenberry January 24th, 2012 at 3:20 pm
  • You may be interested in looking at free cash to invested capital. It is similar to to ROEV. It differs in that cap ex is now considered and that cash is not removed.

    Ron February 5th, 2012 at 7:31 am
  • may i know the number for the 1st quintile? I think it should be at least 30%?

    fon March 28th, 2012 at 9:22 pm
  • Yes. How about comparing 2 recently popular metrics:
    free cash flow to invested capital (CROIC)
    free cash flow to EV (just to compare against CROIC and net cash flow to EV)

    Melon May 6th, 2012 at 9:07 am

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