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You know I am a big supporter of combining a few different valuation measures to find undervalued companies, as it helps you to find companies that are undervalued from different points of view, for example based on earnings and cash flow.

The first such indicator I wrote to you about was the Value Composite One (included in the screener) developed by James O'Shaughnessy.

### But it has a problem

The problem with the Value Composite One indicator is that it includes the Price to Book ratio.

I do not have anything against you using the price to book ratio to find undervalued companies (it works best after a large correction), but it also underperforms the market for long periods of times.

You can read more about problems with the price to book ratio here: Be careful of this time tested value ratio.

### To solve the problem

Because of this problem we decided to develop our own composite valuation indicator, which we called Q.i. Value.

Not only does it exclude the Price to Book ratio, it also includes all the best valuation ratios we have tested up till now, including the work from the research paper Quantitative Value Investing in Europe: What Works for Achieving Alpha.

Qi Value ranks the whole universe of companies (around 22,000) in the screener using four valuation ratios and thus helps you to select the most undervalued companies from different points of view.

### How is it calculated?

Q.i. Value is calculated with the following ratios:

EBITDA Yield

Which is calculated as: Earnings before interest, taxes, depreciation and amortisation (EBITDA) / Enterprise Value

Earnings Yield

Calculated as: Operating Income or earnings before interest and taxes (EBIT) / Enterprise Value

(Read more about earnings yield here: A simple ratio beats the world’s best value funds)

FCF Yield

FCF (Free cash flow) Yield is calculated as Free Cash Flow / Enterprise Value
And free cash flow is equal to cash from operations - Capital expenditure

Liquidity (Q.i.)

It thus gives you an indication of how high a company’s yearly traded value per share is compared to its profits. A high value thus means low traded value compared to profits and thus a larger chance of the company’s shares being miss-priced.

A low value means high traded value to profits which means more analysts may follow the company giving you a smaller chance that the company is miss-priced.

It can thus help you to identify companies with large controlling shareholders or a stable base of shareholders where traded value is low and thus less analyst interest because they cannot make money in the trading of the company’s shares.

(Read more about Liquidity Q.i. here: Liquidity (Q.i.) indicator identifies neglected (miss-priced) companies)

The exact definition of all the ratios can be found in the Glossary.

### Does it work? Yes, 421% vs index 71%

This all sounds very interesting, but does it work? You may be asking yourself.

We of course also wanted to know and tested the Qi Value indicator thoroughly to make sure it works before telling you about it.

We tested the Qi Value indicator worldwide (22,000 companies in all the developed markets), against six other valuation ratios as well as the market index over the 14 year period from May 2001 to July 2015.

The following table summarises the results

14 year back test summarised

Click table to enlarge

Source: www.quant-investing.com

CAGR (Compound Annual Growth Rate)

We tested the Qi Value indicator against the following ratios:

• Earnings Yield (EY)
• Price to Free Cash Flow (P/FCF)
• Price to Earnings (PE)
• Earnings before interest, taxes, depreciation and amortisation Yield (EBITDA Yield)
• Price to Sales (PS)
• Price to Book (BP)

### Qi Value is a lot better

As you can see in the above table Qi Value performed better than all the other ratios, except that the average return of the Price to Sales ratio was higher.

Apart from that the QI Value had a:

• The highest compound annual growth rate over the 14 year period
• The lowest standard deviation which means QI Value returns were not as volatile as the other ratios
• The highest Sharpe ratio (higher is better) which means the Qi Value indicator would have given you higher risk adjusted returns. Here is the Sharpe ratio definition.

### Start using Qi Value in your portfolio right now

Where can you find it?

Q.i. Value indicator, like all ratios and indicators in the screener, is very easy to find and use.

You can select it in any one of the four funnels (or filters) as shown below.

Qi Value is one of the last items under heading Valuation.

### Get the most undervalued companies

To select the most undervalued companies use the slider from 0% to as far as you would like to go. The top 30% most undervalued companies are selected in the image below.

### Combine Qi Value with your investment strategy

Once you have selected undervalued companies with Qi Value you can of course add your favourite ratios or indicators, for example:

Momentum

Piotroski F-Score

Market leaders (large companies on steroids)

Top dividend paying companies

### The best valuation ratio you can use

From all the research we have done to date the Qi Value indicator is without a doubt the best valuation ratio you can use because it finds undervalued companies based on different views of a company’s financial statements.

And as you saw its results speak for themselves, higher returns with lower volatility, something I am sure you find attractive.

Wishing you profitable investing

Tim du Toit