The value factor—the difference in returns between glamour growth stocks and distressed value stocks—is probably the most researched of all the factors in the “factor zoo.” Unlike some other factors, its existence isn’t debated, at least not among academia.
The reason is that, as my co-author Andrew Berkin and I demonstrate in “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today,” the value premium has been persistent across long periods of time and different economic regions, pervasive across the globe and even asset classes (cheap assets have outperformed expensive assets) and, while the most common metric used to define value has been the book-to-market (BtM) ratio (as in Fama and French), it has been robust to many other definitions. In addition, it’s implementable (survives transaction costs).
That said, there’s great debate about the value premium regarding its source. Is it risk-based, behavioral-based or perhaps a combination of the two?
Over the past several years, several papers have contributed to the literature and the debate, the common theme being that enterprise value was used as the value metric. The enterprise multiple (EM) is calculated as enterprise value (EV = equity + debt + preferred stock - cash) divided by earnings before interest, taxes, depreciation and amortization (EBITDA = operating income + depreciation + amortization).
Today we’ll look at three papers that have investigated the ability of enterprise value to explain the cross section of returns and provide insights into the source of the value premium.
The Significance Of Enterprise Value
The first paper we’ll examine is “New Evidence on the Relation between the Enterprise Multiple and Average Stock Returns,” which was published in the December 2011 issue of the Journal of Financial and Quantitative Analysis. The authors, Tim Loughran and Jay Wellman, were motivated to investigate this issue by the increased use of enterprise value as a measure of a firm’s value.
As the authors explain, the use of enterprise value is intuitive: “Firms with a high enterprise multiple are by definition selling for a high valuation for a given dollar of operating income compared to companies with a low EM ratio. These high enterprise multiple firms have stronger growth opportunities, lower costs of capital, and thus lower expected stock returns than low enterprise multiple firms.” Their data sample covers the period July 1963 through 2009. Following is a summary of their findings: