EV/EBIT: The most underrated price ratio
There’s plenty of discussion regarding what the best financial ratios are out there. On one extreme, we have beginning investors who swear by the efficiency of P/E and P/B. On the other hand, more professional investors look at ratios such as EV/FCF, P/FCF, EV/EBITDA, PEG etc. What is not often mentioned is EV/EBIT( Enterprise Value/ Earnings before interest and taxes).As we find out below, investors should pay attention to EV/EBIT much more than they currently do.
Two researchers and investment managers,Wes Gray and Tobias Carlisle conducted research on the compounded annual growth rate of the companies that had a greater market capitalization than the 40 percentile of the NYSE breakpoint at June 30th of each year(1964-2011). They found out that EV/EBIT is the best performing price ratio on a raw compounded annual growth rate. EV/EBIT generated a CARG of 14.55% per year over the full period. The second best performer was EV/EBITDA with 13.72%, then book to market (BM) with 13.11%, followed by earnings yield with 12.44%. Interestingly, but perhaps not surprisingly, the forward earnings estimate performed the worst, earning just 8.63%, underperforming even the S&P 500 by nearly 1% per year.
What’s even more interesting is that EV/EBIT had the best risk volatility(Sharpe Ratio), downside volatility( Sortino ratio) and the lowest drawdowns. If you want to increase your chances of generating alpha, then incorporating EV/EBIT in your investment strategy is a no-brainer.