Is EV/EBIT a good indicator of cheapness?
Today, we are testing a EV/EBIT, which is the market value indicator. As you can on the equation below, it takes market capitalization of the given company and adjusts it to the price, which you need to pay, if you would like to purchase it.
The gauges, that use the Enterprise Value evaluate better the true value of the company, because during the takeover you need to buy back all the company’s shares (common and prefered), pay back the debt, and after that, the cash and cash equivalents will be yours. Therefore it factors in the debt and cash and the luck of this feature is the serious limitation of P/E ratio. EV/EBIT tells us, how much the investors are willing to pay for one unit of operating profit. The lower the value of this indicator, the cheapest the company is.
As always, we have divided the market into 10 groups; from the cheapest ones to the most expensive, according to EV/EBIT. We included only stocks which had a price higher than 20 p. and a volume over 8m p.. Below, you will find the curves of capital for each such created folio:
1. Extremely cheap stocks
3. Cheap stocks
4. Quite cheap stocks
5. Slightly cheap stocks
6. Slightly expensive stocks
7. Quite expensive stocks
8. Expensive stocks
9. Very expensive stocks
10. Extremely expensive stocks
It is quite visible, that the first two folios regain their value quicker, than the market after the bear market in 2008. As we go down, and look on the more expensive folios, their performance becoming worse. We have two groups, that diverge from this trend (num. 5 and 10).
We have established the divisions of EV/EBIT value for each portfolio:
Thanks to the fact, we will know on which stocks to look at, after we will establish which group produce the highest returns and has got another features we desire.
Let’s start with the most important characteristic – ANNUAL RETURN. We compare this value for each folio with the unweighted index of all shares traded on the LSE (during tested period it has been 9,75% annually). The data presented on the chart below is smoothed by a simple moving average in order to better track the trend:
As we can see, cheaper stocks provide higher returns and will beat the market in the long run. First six folios are on average above the market and because of this fact we can . Folios from 7 to 9 consistently perform worse and the last group stand-off from the trend. We can be moderately satisfied with this results. The two cheapest group outperform the market consecutively about 2,4 p.p. and 2,0 p.p.. In the perspective of 10 to 20 years it is very generous additional return. The border of cheapness is around EV/EBIT equal to 17 (group num. 6).
Thereafter, we would like to check how much time each folio has been above the market. It is very important, because we do not want to suffer loses for too many periods. On the table below you can check this quality:
We can see the same trend as on the previous chart, but this time is much more regular and smooth. There is clear conclusion; the cheaper the stock, the more time it spends above the unweighted index. However, the best folio spends only 60% of time above market, which is not so much in comparison to the best result for P/E indicator (75% of time above). The last four groups more often are below the market, than above, which is very undesirable and it is better not to invest in these assets.
What about the risk? How much each folio will lose during the bear markets and other corrections, comparing to the unweighted index? To answer these questions, look on the chart below:
In order to establish the score, we take one year windows (one month jump) and we look for the one, during which the folio has performed the worse in comparision to Index. Once again the first six folios the best results, which in this situation means, that they have the lowest declines. As we can see, the best performance in this feature, shifts from the first two groups, to the groups num. 5 and 6. Once again, folio num. 10 stand out from the regularity we can observe. Although, the difference is not as big as in the test of P/E ratio, so we will ignore it.
The last important attribute for us, it is how much “Pearl” we can find in each group in comparison to the bad-performers. Let’s look on the chart below:
Unfortunately, in comaprision to P/S and P/BV tests, no regularity can be found here. Moreover, the first three groups contain more bad, than good performers, so even if the whole folio produces great annual result, we cannot rely, that we will find many superb companies among it. Folios num. 4, 5, 8, 9 and 10 have almost tha same distribution of good and bad stocks. Put it another way, EV/EBIT does not give an edge in searches for great stocks, which earn more than 50% a year.
- In matter of EV/EBIT, cheap stocks earns more, than expensive ones,
- They spend more time over the market, than expensive ones,
- Border of cheapness is somewhere near to EV/EBIT = 17,
- EV/EBIT cannot be use for the “Pearls” searches.