What is a value composite?
“Composite” means “put together”. In general, a composite indicator is created when individual indicators are combined into a single index on the basis of an underlying model of the multidimensional concept to be measured. The Value Composite measures whether a company is undervalued. To do this, the Value Composite uses several valuation ratios that are intended to provide indications of a possible undervalued share.
Value Composite is therefore an investment strategy designed to help investors select the right investments. Basically, the strategy is based on the idea that higher returns can be achieved by looking for undervalued companies on the basis of several different valuation ratios than by using a single valuation ratio. James O’Shaughnessy is the inventor of the Value Composite and the Trending Value Strategy. In his book “What Works on Wall Street”, James O’Shaughnessy showed that companies selected on the basis of multiple valuation metrics outperformed companies undervalued on a single metric 82% of the time.
The valuation ratios of the three Value Composite
In total, there are three different value composites, each based on different valuation ratios:
Value Composite One (VC1)
The Value Composite 1 is based on the following valuation ratios:
Price-to-book ratio
This ratio compares the market capitalization of a company with the book value of the company. For example, the company’s share price per share is divided by the book value per share. A price-to-book ratio of less than 1 means that the price of a share is lower than the book value – which includes, for example, real estate, warehouses, cash and other tangible assets – see also the article on the balance sheet. The share is therefore undervalued and can offer a good investment opportunity.
Price/sales ratio
The price/sales ratio compares the share price of a company with its revenue. Here, too, the smallest possible figure is considered advantageous. A ratio of less than 1 means that an investor has to invest less than CHF 1 for every CHF 1 in revenue – but this is very rare or never the case.
EBITDA/enterprise value (EV)
EBITDA/EV uses a company’s cash flows to assess the value of a company. When EBITDA is compared to enterprise value, an investor can see if a company has cash flow problems. A company with healthy cash flow will have a high value. Banks also pay attention to EBITDA as it is an indicator of the company’s ability to service debt and repay the principal of new debt.
Price/cash flow ratio
The price/cash flow ratio compares the share price with the operating cash flow (OCF) per share. OCF includes non-cash expenses such as depreciation and amortization. The price/cash flow ratio is particularly useful for evaluating shares that have a positive cash flow but are unprofitable due to high non-cash expenses.
Price-earnings ratio
The price/earnings ratio puts the current share price in relation to earnings per share (EPS). Companies with a low price/earnings ratio are often considered value stocks. This means that they are undervalued because their share prices are trading lower in relation to their fundamentals.
Value Composite Two (VC2)
The Value Composite 2 is based on the same valuation ratios as the Value Composite 1, plus the shareholder return. The Value Composite Two is also part of the Trending Value strategy.
Shareholder return
The shareholder return– also known as total shareholder return (TSR) – is the total amount that an investor earns from an investment, in particular from shares or units.
Value Composite Three (VC3)
The Value Composite 3 is based on the same valuation ratios as the Value Composite 1, plus the buyback yield. Some investors do not care whether a company pays a dividend, or they want to avoid it as it can be very highly taxed. In this case, the shareholder return, which is used as the final valuation indicator in Value Composite 2, would be superfluous.
Repurchase yield
The repurchase yield is the repurchase of outstanding shares in relation to a company’s existing market capitalization. If a company buys CHF 50 million worth of its own shares and its market capitalization is CHF 500 million, the buyback yield would be 10%. Companies with high buyback yields should be looked at more closely.
How is the Value Composite calculated?
The companies are evaluated on the basis of the respective key figures – i.e. the key figures for Value Composite 1, Value Composite 2 or Value Composite 3. The evaluation is initially carried out at key figure level. Each company receives a rank from 1-100 for each individual key figure compared to the other companies in the data set. For example, if a company’s price/sales ratio is among the lowest 1% of the data set, it receives a price/sales rank of 1. However, if the company has a price/sales ratio that is among the highest percentage of all companies in the data set, the company receives a price/sales rank of 100. A rank of 50 is considered neutral. The rank 50 is also often used if a key figure is not available in a data set. The reverse is true for some key figures, for example EBITDA/EV. If a company is in the top 1%, it is given a rank of 1 for this key figure. This makes sense because a higher EBITDA in relation to the company value is better than a lower one.
The same calculation is repeated for each of the metrics. Once all companies have been ranked in relation to all valuation metrics, all values of the valuation metrics are added together for each company. All companies are then ranked in percentiles (from 1 to 100) in this combined ranking. This final result is called the Value Composite. A Value Composite of 1 means that the company is among the 1% most favorable companies according to these factors.
Does the Value Composite work?
O’Shaughnessy tested the three different value composites (VC) with the following results:
- Value Composite 1: Using this metric, his backtests showed an annualized return of 17.18%.
- Value Composite 2: O’Shaughnessy uses this metric in his Trending Value strategy. His backtests showed a 12 basis point improvement in annual total return to 17.3%, with a lower standard deviation and less downside risk.
- Value Composite 3: This Value Composite achieves an even higher return of 17.39% per year, albeit with a slightly higher standard deviation compared to Value Composite 2.