Expected Returns and the Enterprise Multiple

In a recent article for Advisor Perspectives, BAM Alliance director of research Larry Swedroe reports findings of a new study that show price-to-enterprise value (EM) as a more powerful predictor of expected average returns than the more traditionally used price-to-book ratio.

“That research also sheds light on the question of whether the value premium is risk- or behaviorally-based,” Swedroe writes, adding that this debate has been “raging for 25 years.”

Swedroe outlines past research on the topic, citing studies from 2010 and 2015 as well as the results of the recent study, which were published in November of last year in The Journal of Portfolio Management. “A key question in asset pricing,” the report stated, “is whether high average expected returns associated with value stocks and low average expected returns earned by glamour stocks are compensation for risk or a result of systematic mispricing.”

The recent study created test portfolios “by sorting stocks on EM and 11 proxies for the ex-ante fundamental value of the stock,” which are “anomalies from the traditional finance view that risk and return should be related,” which included such variables  as financial distress, net stock issuance. Momentum, gross profitability, asset growth and return on assets.

The study found that the EM effect is primarily due to mispricing rather than higher systematic risk, and that it is stronger when market sentiment increases— “further evidence that the effect is driven by mispricing.”