How and why to implement an EBIT to enterprise value investment strategy
Earnings before Interest and Taxes (EBIT) to Enterprise Value (EV) is truly the 80/20 valuation ratio when it comes to quantitative investing.
It will nearly always give you the highest returns
You can compare it to any single ratio, over most time periods, and it will nearly always give you the best returns of any ratio you care to test.
In this article I show you, through back tests, why EBIT to Enterprise Value is a great strategy as well as how, step by step, to implement it in your portfolio.
EBIT to Enterprise Value = Earnings Yield
In the screener we call EBIT to Enterprise Value Earnings Yield and I will use the both terms in this article - just so you know Earnings Yield = EBIT to Enterprise Value.
Returns of EBIT to EV
Here are the back tested returns you could have earned if you used and EBIT to Enterprise Value strategy to invest in Europe over the 12 year period 13 June 1999 to 13 June 2011.
Source: Quantitative Value Investing in Europe: What works for achieving alpha
Q1 (Quintile 1) represents the cheapest 20% of companies in terms of EBIT to Enterprise Value and Q5 (quintile 5) the most expensive.
Best for medium to large companies
As you can see the strategy worked best for medium and large companies.
Before I show you how you can improve this investment strategy first some information on how we tested.
We only use historical accounting data and no forecasts. The reason being is that there is ample evidence that forecasts cannot be relied on. For example, in his excellent book, ‘The New Contrarian Investment Strategy’, David Dreman mentioned a study that used a sample of 67,375 analysts' quarterly estimates for companies listed on US stock exchanges.
The study found that the average analysts’ error was 40%, and that the estimates were misleading two-third of the time!
So forecasted numbers are just about useless!
The backtest universe and benchmark
Our backtest universe is a subset of companies in the Datastream database containing an average of about 1500 companies in the 17 country Eurozone market during our 12-year test period (13 June 1999 to 13 June 2011).
We excluded banks, insurance companies, investment funds, certain holdings companies, and REITS.
We included bankrupt companies to avoid any survivor bias. Bankrupt companies, or companies that were taken over, returns were calculated using the last stock market price available before the company was delisted.
We excluded companies with an average 30-day trading volume of less than €10 000.
It was not a good time to invest in stocks
The test period was most certainly not a good time to be invested in stocks. The 12-year period we tested included a stock market bubble (1999), two recessions (2001, 2008-2009) and two bear markets (2001-2003, 2007-2009).
In spite of all the substantial movements, over the whole period it was essentially a sideways market, as Vitaliy Katsenelson defined in his book, ‘The Little Book of Sideways Markets’.
Holding periods and quintile tests
Each year all the portfolios we tested were formed on 16 June. We chose 16 June as most European companies have a December year-end and by this date all their previous year-end results would be available in the database.
The annual returns for our back test portfolios were calculated as the 12-month price change plus dividends received over the period. Returns were compounded on an annual basis.
This means each year the return of the portfolio (dividends included) would be reinvested (equally weighted) in the strategy the following year.
The portfolios were all constructed on an equal-weighted basis.
In order to test the effectiveness of a strategy, we divided our back test universe into five equal groups (quintiles), according to the factor we were testing. For example, when testing a low price-to-book (PB) value strategy, we ranked our back test universe from the cheapest (lowest PB) to the most expensive (highest PB) stocks.
The cheapest 20% of companies were put in the first quintile (Q1), the next in the second, and so on, with the 20 % of companies with the highest price-to-book value in the fifth quintile (Q5).
How you can improve the earnings yield investment strategy
You can improve your returns substantially if you combine EY with another ratio or indicator as the table below clearly shows:
Best combination – Momentum
The best way to increase your returns was to combine EBIT to Enterprise Value with Price Index 6 months (6 months momentum) or Price Index 12 months (12 months momentum).
How to implement this strategy in your portfolio
This is how you can implement this strategy in your portfolio using the screener:
- As the first factor or filter select the 20% of companies with highest Earnings Yield (EBIT/Enterprise value)
- As a second factor select the 20% of companies with the highest Price Index 6m (six months price momentum)
- Select the countries where you would like to invest
- Set your minimum trading value per day - $125,000 in the image below
- Select the minimum market value of companies you would like to look for - $65m in the image below
- Click on the filter button to run your screen
Click image to enlarge
In the results table click on the Earnings Yield column heading twice to sort the companies by earnings yield from high to low (the higher the Earnings Yield the more undervalued the company is).
Click image to enlarge
You now have a list of companies that fits this investment strategy.
Limit your losses
We strongly recommend that you use a strategy to minimise your losses. You can read more about that here: Truths about stop-losses that nobody wants to believe
Exact definition – in glossary
You can see the exact definition of all the ratios and indicators in the Glossary
You can of course combine EBIT to Enterprise Value with other valuation ratios and indicators. Here is a list of other article you will find helpful:
This article tells you about Qi Value – which ranks the screener’s whole universe of companies (around 22,000) using the four valuation ratios we have tested with the best results. One of the four ratios is EBIT to Enterprise Value.
This article shows you how a simple quantitative value strategy (using just one simple ratio EBIT to Enterprise Value) outperformed the world’s best value investment funds
This article shows you exactly how and why you can implement a simple quant strategy that does not rely on short term rebalancing – in fact the holding period is three to five years.
This article shows you exactly how to implement the Quality Value Momentum (QVM) investment strategy which contains the best ideas from our research paper Quantitative Value Investing in Europe: What works for achieving alpha as well as all the research we have done since then.
The strategy makes use of EBIT to Enterprise Value and returned an astounding +1142% over 13 years!
In December 2010 two friends finished an interesting research paper they called Systematic Value Investing: Does it really work?
With this paper they wanted to find:
- The best investment strategy in Europe over the 11-years from June 1999 to June 2010
- If small portfolios perform better than large portfolios
- If 30 stock portfolios do better than 50 stock portfolios
What they found was really interesting and I asked them if I can write it up to share with you here.
This article shows you a simple ratio you could use to increase your returns, irrespective of what investment strategy you follow - also your returns of an EBIT to Enterprise Value investment strategy.
Your EBIT to Enterprise Value analyst
Wishing you profitable investing
Tim du Toit
PS To get an EBIT to Enterprise Value investment strategy working in your portfolio today simply sign up right here.
PPS It’s so easy to put things off, why not sign up right now.