Value Ratings
Value Ratings, which use a scale of 0 – 5, predict the relative expensiveness of a stock as an investment. Stocks with ratings closer to 5 are likely to be more timely investments compared to those with ratings closer to 0.
All ratings should only be used to complement your own due diligence when making investment decisions.
Value Ratings Introduction
Value Ratings are determined by a proprietary algorithm that incorporates a stock’s quality and valuation. This approach aims to identify which stocks could be opportune investments at their current prices.
Over the long-term, the performance of a stock primarily depends on the quality of the underlying company. However, the stock’s price is also a key determinant of investor success; paying a high price for a business’s cash flows increases the risk of the investment. The shorter an investor’s time-horizon, and the more valuation plays an important role in the investment outcome.
High-quality stocks with low valuations tend to receive the best Value Ratings (closer to 5), while low-quality stocks with high valuations tend to receive the worst Value Ratings (closer to 0).
For more on the components of the Value Ratings, see Value Ratings Components. Over time, RatedA may update the Value Rating algorithm.
Value Ratings Explanation
3.33 – 5.00: If an investor is looking for undervalued stocks to add to his or her portfolio, these stocks may be the best candidates for consideration.
1.66 – 3.33: An investor holding a stock at these levels should consider whether it is appropriate to continue to hold that stock in his or her portfolio.
0.00 – 1.66: An investor holding a stock at these levels should contemplate if it is overvalued. An investor would not usually consider these stocks for purchase.
Value Ratings Components
Valuation: Value investing is built on the notion that cheaply priced stocks tend to outperform pricier stocks over the long term. The lower the price paid for a stock, the higher the expected returns.
Cheap companies can provide a “margin of safety” – the estimation that a stock’s current price is less than its intrinsic value when conservative assumptions of the future are applied.
That is because the cheaper a stock is, the lower the required rate of return for a successful investment outcome. Conversely, the more expensive a stock is, the higher the required rate of return for a successful investment outcome. In practice, this translates to higher risk.
Value Ratings uses the ratio of a stock’s price to its free cash flow, also known as the FCF multiple, as the primary measure of valuation. The price to earnings (PE) ratio is used instead for banks and insurance companies.
Quality: The integration of the quality component into Value Ratings is designed to avoid the pitfalls of “value traps“. These are stocks that appear cheap but are actually not due to their lack of quality.
High-quality companies share some common characteristics. They possess a moat that serves to protect profits and market share from competitors, leading to more durable cash flows.
These companies are also highly profitable; they typically generate better returns on capital and have an easier time growing cash flows.
Lastly, high-quality companies are relatively safe from uncertainty; by having less variability in future expected outcomes, their cash flows are more predictable.
High-quality businesses often appear expensive compared to their counterparts. However, this does not necessarily mean they are overvalued; high-quality companies deserve to trade at higher valuations.
Why Use Value Ratings
The long-term outperformance of a value investing strategy relative to the broader market is well documented in financial literature. And many very successful investors have used value investing to generate exceptional returns.
Benjamin Graham, Warren Buffett’s teacher and mentor, stressed the importance distinguishing the price of stock from the value of its underlying business. Seth Klarman largely outperformed the market by buying unpopular assets while they are undervalued and seeking a “margin of safety”. Joel Greenblatt pioneered a very simple and successful investing formula that relies heavily on a stock’s valuation.
Undervalued stocks can be excellent investments, particularly for contrarian investors who can capitalise on market volatility and the associated fluctuations in stock prices. By targeting inexpensive stocks, investors can reduce valuation risk: the risk that overpaying for an asset will result in inadequate returns over the holding period
Special Considerations
Here are some special considerations when using our Value Ratings.
Consider the following:
- The quality of the ratings depends on the accuracy of financial data provided by third parties, including the companies in our coverage.
- This approach is more short-term oriented, as both buying and selling is primarily driven by market volatility. Since stock prices are frequently subject to remarkable fluctuations, this could lead to increased trading activity, resulting in higher fees, taxes, and potentially lower investor returns.
- The valuation component of Value Ratings uses backwards looking price to FCF (P/FCF) and price to earnings (PE) ratios as the primary metric for business valuation. While this reduces the risk of overestimation associated with forward-looking metrics, it means that our ratings may not reflect the possible impact of recent business developments. Investors should always do their own research before making a trading decision.
- The quality component of Value Ratings uses Quality Ratings as the primary metric for business quality. Quality Ratings are typically updated annually, shortly after companies publish their annual reports. Quality Ratings are focused on long-term outcomes. While the overall quality of a company does not change materially from quarter to quarter, our ratings may not reflect the possible impact of recent news and business developments. Investors should always do their own research before making a trading decision.
- Value Ratings and all related publications are not personal recommendations for any particular investor or client. All opinions provided are based on sources believed to be accurate and are written in good faith, but no warranty, representation, or guarantee, whether expressed or implied, is made as to the accuracy of the information provided by our service.
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