EBITDA/EV: finding stocks that beat the market

In the field of financial analysis, the quest for indicators to assess a company's future stock market performance is never-ending. Among these tools, the EBITDA/EV ratio (Earnings Before Interest, Taxes, Depreciation and Amortization/Enterprise Value) is proving to be a relevant indicator for investors. Let's take a closer look at this analytical tool and its various applications.

EBITDA/EV: Introduction to the fundamentals

EBITDA/EV is a ratio that relates a company's ability to generate operating cash flow to its total value. This ratio is part of the family of valuation multiples, alongside PER or Price/Book.

The importance of this ratio lies in its ability to provide a standardized view of a company's operating profitability, irrespective of its financial structure and depreciation policy.

Unlike other, more traditional ratios, EBITDA/EV takes into account all the capital committed to the company, offering a more complete view of its valuation.

This multiple is particularly appreciated by financial analysts, as it enables relevant comparisons to be made between companies in the same sector, even if they have different financial structures.

Understanding how to calculate and interpret the ratio

EBITDA/EV is calculated by dividing EBITDA by enterprise value (EV). EBITDA represents earnings before interest, taxes, depreciation and amortization, while EV corresponds to market capitalization plus net debt.

The higher the ratio, the more the company is considered potentially undervalued. Conversely, a low ratio may indicate overvaluation or strong growth prospects anticipated by the market.

Interpretation should always be made in comparison with peers in the sector. A ratio of 10% may be excellent in a mature sector, but mediocre in a fast-growing one.

The comparative advantages of EBITDA/EV

EBITDA/EV has the major advantage of being less sensitive to differences in accounting conventions between countries, thus facilitating international comparisons.

This ratio also eliminates the effects of financial structure, making it possible to compare companies with different levels of debt.

Using EBITDA rather than net income neutralizes the impact of depreciation and amortization policies, which can vary significantly from one company to another.

Taking into account enterprise value rather than market capitalization alone offers a more complete view of a company's real value.

Backtest

To assess the effectiveness of this ratio on the Swiss and French markets, I ran a backtest from 2004 to 2024. Stocks were ranked according to their EBITDA/EV, from lowest to highest, and then divided into quintiles. I used EBITDA data for the last 12 months divided by the company's current value. The process was repeated every year during the observation period, enabling an in-depth analysis of the performance of each quintile.

The results have been adjusted to take into account dividends, fractional shares and other corporate events that may influence stock value.

In contrast to other ratios analyzed so far, EBITDA/EV fared slightly better in the backtest compared to within business sectors (and not within industries). Sectors represent broader economic entities. I will therefore only present the results obtained using this method, which is the most relevant. It should be noted, however, that the difference is not significant with industries.

Backtest results (average annual performance in CHF)

• in Switzerland, best quintile: 11.02% (market 8.36%)
• in France, best quintile: 6,75% (market 3,06%)

By company size:

• in Switzerland: doesn't work very well for Big & Mid Caps, but works well for Small & Micro Caps (11,81%/year).
• in France: ditto, doesn't work very well for Big & Mid Caps, works well for Small & Micro Caps (7.2%/year).

Lessons from the backtest

• EBITDA/EV works on both markets analyzed. Top-ranked stocks beat the market.
• EBITDA/EV works best with small and very small companies, whether in France or Switzerland.

There gross margin growth (comparison within industries) is still the best performing single ratio we have studied so far in Switzerland (13.4% per year for the best quintile). In France, it's still dividend yield (within the industries) which performs best on the whole market with 7%/year.

Conclusion

In short, the EBITDA/EV ratio is an interesting indicator for investors wishing to assess the future stock market performance of companies. By offering an in-depth analysis of operating profitability, this ratio enables relevant comparisons within the same sector, while minimizing the impact of accounting differences and financial structures. Finally, the backtest results show that EBITDA/EV can be an effective tool, even if it is not the best single ratio we have seen to date.

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