Free Cash Flow to Enterprise Value Backtest

The free cash flow to enterprise value ratio is a rather sophisticated valuation ratio that should be a part of every value investors toolkit.  It is inspired in part by the discounted cash flows method of company valuation. I have previously backtested the price to free cash flow ratio, so it is high time that I also backtest the free cash flow to enterprise value ratio.

This is especially true, since I recently received the following email from a Fat Pitch Financials reader that inspired this free cash flow to enterprise value backtest:

I love what you do and I’m a big fan, it’s difficult to find proper information in the sea of finance but I find safe haven in websites like yours.

I was impressed with the results of the P/FCF so much I was curious to know what an EV/FCF would look like. My suspicion is that it will perform better than using only price.

Thank you for keeping this blog going!

For this backtest, I calculated the free cash flow to enterprise value as follows:

Free Cash Flow to Enterprise Value  = FreeCashFlowTTM / EnterpriseValue

In Portfolio123, Free Cash Flow (FCF) is calculated as cash from operations minus capital expenditures minus total dividends paid. I’d prefer not to subtract out dividends, but this is not likely to really impact the results of the backtest. Cash from operations is the amount that a company is taking in from its main business operations. Capital expenditures is the amount spent on equipment and property to maintain the current productivity of the business and to drive future growth. The remainder of the cash after these capital expenditures is how much of a company’s profits are available to return to shareholders.

While market capitalization measures the total value of the publicly-traded stock, enterprise value (EV) goes further and attempts to measure the value of the entire company. Many see it as the minimum price someone seeking to acquire the company would have to pay. The formula we used by Portfolio123 is as follows:

Market capitalization
+ total debt
+ value of preferred equity
+ minority interest (redeemable + nonredeemable)
– cash & equivalents

It is possible for an extremely cash-heavy company to have a negative enterprise value but we are not considering those situations in this backtest.

I used the data and backtesting tool provided by Portfolio123. The Portfolio123 backtesting eliminates the problem of survivorship bias by using point-in-time and retaining data on stocks that have gone to zero. This backtest uses a similar filtered universe of stocks as my recent change is shares outstanding backtest. The only major difference is that I increased the minimum market capitalization to $1 billion to better match the size of companies in the S&P 500 equal weight benchmark that I use for these backtests. I’ve designed the filtering criteria for this backtest with a focus on enhancing data quality. The filters include the following criteria:

  1. No OTC stocks. Stocks not traded on the New York Stock Exchange, NASDAQ, or American Stock Exchange markets are excluded. The quality of fundamental stock data for OTC can be somewhat lower and less timely that that for stocks traded on major exchanges.
  2. No ADRs. Fundamental data for foreign American Depositary Receipt can include errors due to currency exchange, different accounting standards, and share count.
  3. Exclude the Financial Sector. The concept of free cash flow does not really work the same way for banks and other financial sector companies.
  4. Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000.  This amount was selected so that a $1 million dollar portfolio could hold 100 positions and that each new $10,000 position would not exceed 10 percent of a day’s trading volume. The liquidity test also ensures that the backtest has reliable market price information for any of the stocks that are being tested.
  5. Market Cap > $1 billion. This filter helps match the size of companies analyzed to the size of companies in the S&P 500, which is used as a benchmark for this backtest.
  6. Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks.
  7. Free Cash Flow to Enterprise Value != NA. We want to make sure we are only looking at companies that have valid data for the free cash flow to enterprise value ratio.

After these filters are applied, we are left with approximately 800 to 1,500 stocks. These stocks are then ranked by the criteria being tested; in this case, we are testing the FCF/EV ratio. The lowest 20 percent of stocks ranked by FCF/EV are placed in the first quintile and the next 20 percent in the second quintile and so forth until we have five portfolios of stocks. The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. The following 5 charts display the quintile returns for the free cash flow to enterprise value ratio in red and the S&P 500 Equal Weight Index in blue.  The first quintile includes the companies that have negative free cash flow to enterprise value ratios and the 5th quintile includes the companies that had the highest free cash flow to enterprise value ratios.

Free Cash Flow to Enterprise Value Backtest Returns (2000 – 2015)

FCF/EV ratio backtest 1st quintile backtest
Free Cash Flow to Enterprise Value 1st Quintile

The first quintile clearly and consistently underperforms the S&P 500 equal weight benchmark as expected.

FCF/EV ratio backtest 2nd quintile backtest
Free Cash Flow to Enterprise Value 2nd Quintile
FCF/EV ratio backtest 3rd quintile backtest
Free Cash Flow to Enterprise Value 3rd Quintile
FCF/EV ratio backtest 4th quintile backtest
Free Cash Flow to Enterprise Value 4th Quintile
FCF/EV ratio backtest 5th quintile backtest chart
Free Cash Flow to Enterprise Value 5th Quintile

The top 20% of stocks as ranked by FCF/EV outperformed the benchmark in the 2000 to 2015 time period.

Summary of Results for the FCF/EV Backtest

Backtest results for the FCF/EV ratio
16-year backtest of the Free Cash Flow to Enterprise Value ratio
Average annual excess returns from 2000 to 2015 for the FCF/EV Ratio by Quintile
Average annual excess returns from 2000 to 2015 for the Free Cash Flow to Enterprise Value Ratio by quintile

The first quintile barely exhibited a positive annualized return. The stock of these companies that had negative FCF/EV ratios underperformed the market in 56% of the years in this 16-year test period. The average excess returns versus the S&P 500 equal weight benchmark were a negative 3.05%.  In contrast, the 5th quintile outperformed the benchmark 100% of the time and produced average excess return of 5.82%. Average excess returns seem to increase in almost a linear fashion from the 1st quintile to the 5th quintile, which gives me more confidence that the FCF/EV ratio does have a direct relationship with 1-year stock returns.

Since I changed the minimum market capitalization filter for this backtest to $1 billion when I only set it to $50 million in my old Price to Free Cash Flow Ratio Backtest, it is difficult to directly compare the results.  I will need to redo the price to free cash flow ratio backtest with this new smaller universe of companies that have great than $1 billion in market cap.

What do folks think of my shift to the $1 billion market cap minimum? I had received feedback to increase the minimum size to this number in order to better match the size of companies in the S&P 500 Equal Weight benchmark that I prefer to use when analyzing backtests. I notice now that the S&P 500 Equal Weight total return and annualized returns are now only a bit lower than the returns for the universe of stocks that were tested.  In previous backtests, there was a much larger divergence.

I encourage you to try backtesting other valuation ratios. Just sign up for a free 30-day trial at Portfolio123 and report your findings in the comments section below.

7 thoughts on “Free Cash Flow to Enterprise Value Backtest

  • March 18, 2016 at 6:45 pm

    Awe I was really excited to be able to compare it to the fcf/p. Not all of us invest only in the S&P500. I think this mimimum is a failure to actually understand what the tests are representative of when pertaining to investing in BUSINESSES rather than “stocks”.

  • March 19, 2016 at 3:13 am

    This was a very interesting write-up. I think it’s interesting to see that businesses have a high cash flow compared to the overall price of their business have higher returns. I was wondering if at all you had considered doing this year by year instead of with one point year. I mean remake the portfolios every year based on the TTM free cash flow and the enterprise value. I think that would be more definitive results as from year to year (and quarter to quarter) the fcf and enterprise value will change.

  • March 19, 2016 at 8:47 am

    The portfolios are remade every January from 2000 to 2015.

  • March 19, 2016 at 8:50 am

    I’ll also run the same screen next week with a $50 million minimum market cap. I’ll also run a poll shortly to see if readers want a $50 million or $1 billion market cap minimum.

  • March 29, 2016 at 6:52 am

    Hello George,

    I would like to perform similar backtests for my academic reasearch. I have already registered a P123 acccount, however:

    1) I am not sure how to perform the backtests in the most intelligent and time efficient way.
    2) I did not manage to get the nice chart overviews and data summary as you present here.

    Could you (or anybody else reading this) please give me some advices and tips how to do it correctly? Thank you!

  • April 1, 2016 at 12:04 pm

    You can also do these sorts of backtests with EquitiesLab

  • July 8, 2016 at 10:02 am

    Another interesting back test thanks George.

    I prefer 50 million market cap because I invest my own money and would rather look for ideas where there are less interest by analysts and large investors.

    What may be a better selection criteria is trading volume. For example $100,000 30 day average which should be more than enough for small investors.

    We tested TTM FCF to EV and five year average FCF to EV on European companies over the 12 year period 13 June 1999 to 13 June 2011.

    TTM FCF worked a better than five year average FCF but we found that if you combine TTM FCF with other ratios you get much better returns.

    TTM FCF combined with 12 month share price momentum gave the best result of +755%

    You can read more about the back test here:

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