Why Do Enterprise Multiples Predict Expected Stock Returns?

Abstract

The enterprise multiple (EM) effect has been documented across global stock markets. EM is a robust predictor of expected average returns and generates a stronger value effect than traditional value metrics. We find evidence that the EM effect is primarily attributable to mispricing and cannot be explained by higher systematic risk. We document that earnings announcement returns, forecast errors, and forecast revisions all support the notion that the EM effect is driven by mispricing associated with predictable investor expectation errors. Finally, we show that the EM effect is stronger during times of strong market sentiment, which also supports the mispricing-based hypothesis.

TOPICS: Factor-based models, equity portfolio management, portfolio construction, portfolio theory

Key Findings

• • We revisit the enterprise multiple (EM) effect and document that the EM effect is primarily attributable to mispricing and cannot be explained by higher systematic risk.

• • We document that the EM effect is stronger during times of strong market sentiment, which is further evidence that the effect is driven by mispricing.

• • Over 80% of the alpha associated with the best EM portfolio is generated by the short leg. If managing short positions is costly, these results suggest that the mispricing associated with the high-mispricing EM portfolio is difficult to profitably exploit.