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Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years

Analyzing Valuation Measures: A Performance Horse-Race Over the Past 40 Years

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Published by currygoat
We compare the investment performance of portfolios sorted on different valuation measures.
We compare the investment performance of portfolios sorted on different valuation measures.

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Categories:Business/Law, Finance
Published by: currygoat on Jan 13, 2012
Copyright:Attribution Non-commercial

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01/13/2012

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Electronic copy available at: http://ssrn.com/abstract=1970693
 
Analyzing Valuation Measures:A Performance Horse-Race over the past 40 Years.
Wesley GrayDrexel University101 N. 33
rd
StreetAcademic Building 209Philadelphia, PA 19104wgray@drexel.edu Jack VogelDrexel University101 N. 33
rd
StreetAcademic Building 209Philadelphia, PA 19104 jrv34@drexel.edu November 2011
 
Electronic copy available at: http://ssrn.com/abstract=1970693
 
Analyzing Valuation Measures:A Performance Horse-Race over the past 40 Years.
ABSTRACTWe compare the investment performance of portfolios sorted on different valuationmeasures. EBITDA/TEV has historically been the best performing metric and outperformsmany investor favorites such as price-to-earnings, free-cash-flow to total enterprise value, andbook-to-market. We also explore the investment potential of long-term valuation ratios, whichreplaces one-year earnings with an average of long-term earnings. In contrast to prior empiricalwork, we find that long-term ratios add little investment value over standard one-year valuationmetrics.JEL Classification: G10, G14Key words: enterprise multiple, price to earnings, price to book, free cash flow, gross profits,valuation metrics
 
 We address a basic research question: Which valuation metric has historically performedthe best? Practitioners have relied on a variety of valuation measures, including price to earnings(P/E), and total enterprise value to earnings before interest and taxes and depreciation andamortization (TEV/EBITDA). Meanwhile, academic research (e.g., Fama and French [1992])has traditionally relied on the book to market ratio (B/M) and the more recent gross profitsmeasure (GP) introduced by Novy-Marx [2010].Eugene Fama and Ken French consider B/M a superior metric for the following reason:
We always emphasize that different price ratios are just different ways toscale a stock’s price with a fundamental, to extract the information in the cross-section of stock prices about expected returns. One fundamental (book value,earnings, or cashflow) is pretty much as good as another for this job, and theaverage return spreads produced by different ratios are similar to and, instatistical terms, indistinguishable from one another. We like BtM because thebook value in the numerator is more stable over time than earnings or cashflow,which is important for keeping turnover down in a value portfolio.
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As stated above, Fama and French suggest that different price ratios are “pretty much as good asanother for this job [explaining returns].” We beg to differ. We find economically andstatistically significant differences in the performance of various valuation metrics. Specifically,we examine a large swath of pricing metrics (all expressed in “yield” format):
 
Earnings to Market Capitalization (E/M)
 
Earnings before interest and taxes and depreciation and amortization to totalenterprise value (EBITDA/TEV)
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