The problem with single-factor valuation ratios is that they move “in and out of favor” and can significantly underperform the overall market over any given 10-year period despite their long-term outperformance.
The solution ?
A valuation factor that uses a few valuation measures overcomes this problem by giving you a list of companies that are undervalued based on a few valuation measures and thus more consistent returns.
The use of a “value composite” to measure undervaluation rather using the single valuation ratio of for example price-to-sales or book to market.
O’Shaughnessy found that stocks selected based on the value composite outperformed stocks scoring highest on any single value factor 82% of the time in all 10-year rolling periods between 1964 and 2009. So, a composite that combines several different value factors delivers stronger returns and more consistency than any individual factor !
The VC1 factor or the value composite one is calculated using the following five valuation ratios:
- Price to book value
- Price to sales
- Earnings before interest, taxes, depreciation and amortization (EBITDA) to Enterprise value (EV)
- Price to free cash flow
- Price to earnings
How is VC1 calculated?
To calculate the VC1 factor we assign a percentile ranking (1 to 100) to each of the five valuation ratios for each company.
For example if a company has a price to sales ratio that is in the lowest 1 percent for our database, it receives a rank of 1 (lower is more undervalued) and if a stock has a PE ratio in the highest 1 percent (it is over valued) of the universe it receives a rank of 100. If a value is missing, we assign a neutral value of 50 for the valuation ratio.
Once all the valuation ratios have been ranked we add up all the values for each company and (using this value) rank all the companies in percentiles (from 1 to 100).
Companies that are the most undervalued get VC1 score of 1 those with the worst (most expensive) score get a score of 100.
Our 12 year back test...
As with all the strategies in the screener we have back tested the returns you could have made if you used the VC1 indicator as an investment strategy for the 12 years between June 2001 and June 2012.
Over this period if you bought only non-financial companies (in Europe EU, the UK, Switzerland and the Nordic countries) with the VC1 value of less than 20 you would have earned a respectable 12.36% per year or 283% in total.
This compares very favourably to the 4,86% per year or 73% of all the companies we tested returned over the same period.
We also tested what would have happened if you only bought companies with a VC1 value of more than 80 (in other words overvalued companies).
Over the same 12 year period from June 2001 to June 2012 you would have lost 4.43% per year for a total loss of 40,7% over 12 years.
If you combine the VC1 with another factor like the top 20% of companies in terms of the 6 month Price Index, F-score or shareholder Yield, not only will the number of companies be less but your returns are also very likely to be higher as you saw with the research paper we sent you in 2012.