Value Score
As discussed in the previous article, we have stock scores to evaluate stocks on 3 important factors – Value, Momentum and Quality. In this article, we will discuss the methodology used in computing value score.
Value is a phenomenon where cheap stocks tend to outperform expensive stocks on average. Value-based strategies have a long history going back to the 1920s – popularized by Graham and Dodd. The existence of value premium is well established.
Value score helps you gauge the valuation of a stock with respect to other stocks in the market.
Over the years, researchers have used multiple valuation metrics to define “value”. The original paper by Fama and French used book-to-price (B/P) as the proxy for value. Some investors prefer the popular P/E (or E/P) while others prefer EV//EBITDA or cashflow-based measures.
However, research has shown that using a composite value measure (comprising multiple value measures) yields better results. This makes sense since individual measures can be noisy (due to multiple reasons). Combining multiple measures leads to a reduction of noise.
Therefore, we combine multiple valuation measures to arrive at a single value score. We use Book to Market Cap (B/P), Earnings Yield (E/P), Sales to Price (S/P), FCF yield and inverse of CAPE (3).
For each metric, we calculate a score between 0 and 100 using our standard scoring methodology. We then calculate an aggregate score by summing up the individual scores (equal weight). The stocks are then again scored between 0 and 100 based on the aggregate score to arrive at the final value score.
The bulk of the content for value has been inspired by these 2 papers from AQR: