Value Composite
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In general, a composite indicator is created when multiple indicators are combined into a single index. The aim of the
Value Composite is to measure whether a company is undervalued. The Value Composite uses a variety of valuation metrics (ratios) to identify stocks that are possibly undervalued. In this regard, Value Composite is an investment strategy designed to assist investors when choosing investments. By
searching for undervalued companies on the basis of several different valuation metrics, the strategy aims to achieve higher
returns. Value Composites and the Trending Value Strategy were invented by James O'Shaughnessy. James O'Shaughnessy demonstrates in his book "What Works on Wall Street" that companies selected based on multiple valuation metrics outperformed companies, which seem to be undervalued based on one single valuation metric in 82% of the time.
Three different Value Composites are available, each based on different valuation metrics:
Value Composite One (VC1)
The Value Composite One is based on the following valuation metrics:
Price-to-Book Ratio
To determine the price-to-book ratio, the share price of a company is divided by the book value per share. Price-to-book ratios less than 1 indicate that shares are less expensive than their book value. Therefore, the share is undervalued and may offer a good investment opportunity.
Price-to-Sales Ratio
The price-to-sales ratio compares a company's share price with its sales. Similar to the price-to-book ratio, it is preferable if the price-to-sales ratio is low. A ratio, which is smaller than 1 means that an investor has to invest less than CHF 1 for every CHF 1 of sales.
EBITDA-to-Enterprise Value (EV)
EBITDA-to-EV uses a company's cash flows to evaluate the value of a company. An investor can determine whether a company has cash flow problems by comparing EBITDA to enterprise value. It is important for a company to have healthy cash flows in order to have a high valuation. As a measure of a company's ability to repay new debt and service existing debt, banks also pay attention to EBITDA.
Price-to-Cash Flow Ratio
The price-to-cash flow ratio measures the share price in relation to operating cash flow (OCF) per share. OCF includes non-cash expenses such as depreciation and amortization. The price-to-cash flow ratio can be used to evaluate stocks that generate positive cash flow but are unprofitable due to high non-cash expenses.
Price-to-Earnings Ratio
The price-to-earnings ratio compares the current share price with the earnings per share (EPS). In general, value stocks are those with a low price-to-earnings ratio. In other words, the share prices are undervalued since they trade at a lower price relative to their fundamentals.
Value Composite Two (VC2)
Value Composite Two includes shareholder returns, along with the same valuation metrics as Value Composite One. The Value Composite Two is a component of the Trending Value Strategy.
Shareholder Return
An investor's shareholder return - also known as total shareholder return (TSR) - is the total amount shareholders earn from a stock or share investment.
Value Composite Three (VC3)
Added to Value Composite One, Value Composite Three considers the buyback yield. Some investors prefer not to invest in companies paying dividends because dividends are usually taxed heavily. Other investors are not concerned about whether a company pays dividends. Value Composite Two calculates valuation based on shareholder return, which is not relevant for these investors.
Buyback Yield
The buyback yield represents the repurchase of outstanding shares relative to the existing market capitalization of the company. The buyback yield is 10% if a company buys 50 million francs worth of its own shares, and its market capitalization is 500 million francs. Investors should take a closer look at companies with high buyback yields.
Companies are ranked based on the valuation metrics - i.e., the valuation metrics for Value Composite One, Value Composite Two, or Value Composite Three. First, rankings are conducted at the valuation metrics level. Ranks are assigned to companies based on each individual valuation metric. For example, if a company's price-to-sales ratio is among the lowest 1 percent of the data set, it receives a price-to-sales rank of 1. However, if the company has a price-to-sales ratio that is among the highest percentage of all companies in the data set, the company receives a price-to-sales rank of 100. The neutral ranking is 50. 50 is also often used when a ratio is not present in a data set. For some valuation metrics, a higher ratio is better than a lower ratio, for example, EBITDA/EV. In this case, the reverse applies: If a company is among the highest 1%, it receives a rank of 1 for this metric.
For each valuation metric, the same calculation is performed. As soon as all companies have been ranked on each valuation metric level,
the values of the valuation metrics for each company are added up. Thereafter, all companies are ranked in percentiles (from 1 to 100). The result is called the Value Composite. A Value Composite of 1 means that the company is among the 1% most favorable companies.
O'Shaughnessy tested the three Value Composites (VC) with the following results:
- Value Composite One: In backtests, the annual return was 17.18%.
- Value Composite Two: This metric is a key component in O'Shaughnessy's Trending Value Strategy. The backtests showed an improvement of 12 basis points in annual total return to 17.3%, with lower standard deviation and downside risk.
- Value Composite Three: This Value Composite achieved an even higher return of 17.39% per year, but with a slightly higher standard deviation compared to Value Composite Two.
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