As a stock-market investor, you analyse a company for its financial strength, business outlook and management. But the trickiest thing is valuation. There are many valuation ratios, and different valuation ratios for the same company may give you different pictures. For instance, it is possible that the price-to-earnings ratio suggests that a stock is overvalued, but the price-to-book ratio tells you that it is undervalued.
Secondly, problems may arise when some ratio is not available. For example, the price-to-earnings ratio has no significance in case a company is loss-making. The price-to-book ratio may not be there if the company has accumulated losses on its balance sheet. To iron out the differences among various valuation ratios, James Patrick O'Shaughnessy developed a composite score based on six different valuation ratios. An American investor and founding chairman and CEO of O'Shaughnessy Asset Management, O'Shaughnessy, in his quantitative-investing book What Works on Wall Street has explained how to arrive on the value-composite score. He used the following six valuation ratios to arrive at the composite score:
- Price to book
- Price to sales
- Price to cash flow
- Price to earnings
- Enterprise value to EBITDA
- Shareholder yield
The method includes giving percentile rank to the companies in the selected universe of stocks based on these six parameters and then aggregating the scores. The final percentile score gives the value composite.
O'Shaughnessy used this score as a support factor to other financial-strength-based filters and did not use it as a standalone factor. It is advisable that you use this value composite once you have worked on other financial filters or parameters and use it to find the most attractive company among the shortlisted ones. As explained by O'Shaughnessy himself, the problem with single-factor valuation ratios is that they move "in and out of favour" and can significantly underperform the overall market over any given ten-year period despite their long-term outperformance. In contrast, a valuation composite consisting of six different value factors smoothens out performance in the short term because at least a few of the valuation factors are always in favour and balance out those factors that are out of favour.
Using a value composite is another version of diversification. You don't rely on just one tool to determine value but you have a composite score that reduces the chances of your being wrong.
For better understanding, we have given example of value composite for Nifty 50 companies. Following is the list in the order of attractiveness of the score.
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