The Value Score

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Importance: Highest

Historical Predictive Power: High

How it Relates to Returns: Portfolios of stocks with a Value Score of 10 historically outperformed the S&P500 substantially, and portfolios of stocks with a score of 1 substantially underperformed the S&P 500.

Historical Results - Performance of factor portfolios (no volume limitations) of companies by Value Score

Value Score Performance

What it is: The Value Score is a composite score. It tells you how much you are getting in terms of profits, cash flows, assets, sales, etc. for the price that you pay. It is a relative measurement, so it says nothing about the overall level of the market. Rather, it answers the question: “Given the current market level, which stocks give you the most current value for your dollar of investment?” Tens are the most value, and 1s are the least.

How to use it: Use it to find companies that are selling at a low price relative to their assets and profits.

Limitations of the Value Score: Watch out for companies with a lot of uncertainty or bad prospects for the future (eg. Pharma companies with expiring patents, industries on the decline, etc.).

End of the Summary. Next Indicator: Fundamental Score


Value Score: In Detail

YCharts views a stock investment as much more than purchasing a piece of paper. We see it as buying a small portion of a company. Imagine that you are buying 100 shares of a company that produces cars. If there are 1,000,000 shares outstanding, then you have purchased 1/10,000 of the company.

Here is the interesting part: If you pay a $10,000 for 100 shares, you get exactly the same rights as if you pay $1,000 for the 100 shares. In other words, if you bought at the lower of the two prices, you would get the same amount of benefits for 1/10th of the price. The Value Score helps you to locate the companies that are selling for low prices relative to the benefits they give you. Lets take a look at what the benefits of owning a company are and how the Value Score incorporates them.

The summary of key components are shown here:

Value Score Components

You Own a Company's Net Assets

Imagine you bought all of the stock of the company that produces cars. The first benefit is an ownership right to the physical assets of the company. You get the buildings and plants that it owns, as well as the machinery inside. You also get the company's inventory - the cars that it has built but has not yet sold. Maybe the company also has warehouses full of steel, which you would own.

In addition, you get the financial assets that the company owns. You have a right to its cash and any investments it holds. Anything that customers or other companies owe to you (called receivables, in accounting terminology) now is yours to collect.

Unfortunately, you would also take on the debt that the company owes. The company may owe money to suppliers that produce parts that it uses to build cars. It might also have taken debt from bankers to help fund its growth. Those liabilities are now yours.

Therefore, you own the value of all of the assets less the liabilities. A good approximation of this number is the Book Value of Shareholder's Equity. In the Value Score, we show you how much Book Value of Equity you get for the price you pay.

The value "0.3143" tells you that you get Net Assets of 31.43 cents for every dollar you spend on the company. The bar below tells you you how this value compares to other companies. Each of the five bars represents a quintile that the stock could fall into relative to all valid companies we cover. If the indicator has one bar shaded, it falls somewhere between dead last and the 20th percentile of all companies for Book to Market. This company has two bars shaded. Therefore, its Book Value of Equity/Market Value of Equity is between the 20th and 40th percentile of all valid companies that we cover.

You Own a Right to Future Earnings

The second, and often the most important benefit that you get as a business owner is the right to all of the company's earnings (after all suppliers, lenders, and many other people with contractual rights are paid). For some companies - especially those like service firms and software developers with few fixed assets - this earning potential composes nearly the entire value of the company.

Accounting earnings are complicated creatures. In fact, in his 2010 Letter to Shareholders, Warren Buffet joked that "Regardless of our our business might be doing, Charley [Munger, his partner] and I could - quite legally - cause net income in any given period to be almost any number we would like." Because of this flexibility in net income, we use five measures to determine the value of earnings distributable to investors.

Once again, we look at the components:

Value Score Components

  • Dividend Yield - The amount of dividends paid annually as a percentage of the current price. For example, this company pays 3.04 cents per dollar that you pay to purchase it. Since the bar below has 4 units shaded, this company falls in the second quintile (60th to 80th percentile) for its dividend yield.
  • Price to Sales Ratio - How many dollars you pay for each $1 of sales. In the example company, you pay $2.605 for $1 of sales. This company falls in between the 20th and 40th percentile compared to all other companies for Price to Sales Ratios.
  • Earnings Yield - The previous year's earnings as a percentage of current price. This company earned 4.59 cents for each dollar invested. The company is between the 40th and 60th percentiles for earnings yield, as shown by the yellow bar.
  • Operating Earnings Yield - This company earned 4.56 cents from operations for every dollar invested in it, which is in the 40th to 60th percentile range.
  • Free Cash Flow Yield - The company earned 6.32 cents of cash last year for each dollar invested, which is between the 20th and 40th percentile compared to other companies.

(Note: To keep the score proprietary, we calculate Operating Earnings Yield and Free Cash Flow Yield in a non-standard fashion.)

These measurements are closely related. For a full understanding, read our glossary (better yet, take an accounting class), but here's are a couple of important facts that should help.

These items are all getting at one important fact: how much does the company earn provide to you as a shareholder. To get a sense, you should NOT sum them all up. In fact, they are all related to one another. Here's a very basic way of thinking about it. In the long run:

Dividends ≤ Free Cash Flow ≈ Earnings ≤ Sales

Specifically, dividends can only be paid if the company earns money. Free Cash Flow (the cash the business earns) and Earnings (the accounting earnings the business has) must be similar in the long run, but can differ over periods of time due to accounting laws. Earnings must be less than the total revenues the company takes in (except in very rare circumstances, like when a business has sold almost nothing but sold many profitable investments).

Operating Earnings are similar to earnings, but they only include earnings from the company's core business. For example, if your car manufacturing business earned money by investing in stocks, that is not operating earnings. Operating Earnings only includes money earned from selling and servicing cars.

Turning it All Into One Score: Value Score

To come up with our final Value Score, we create a weighted average of all of these measurements, and then rank companies based on that weighted average. The top 10% of companies earn a score of 10, the next 10% get 9s, etc.

Hence, the companies with scores of 10 tend to be selling for the cheapest prices relative to the underlying benefits they give to shareholders.

An Imperfect Measurement of Value

There are many parts of a company that are valuable but cannot be quantified - brand value and future growth are two obvious ones. The Value Score does not take these into account. However, based on our backtesting results, the Value Score was a strong predictor of future price appreciation. Again, borrowing a quote from the great Warren Buffett:

"Our inability to pinpoint a [value] doesn't bother us: We would rather be approximately right than precisely wrong."

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