In 1995, Applied finance pioneered Quantitative Valuation™ to bridge the gap between fundamental and systematic analysis.
Our proprietary Quantitative Valuation™ approach provides a consistent, objective, repeatable, and sustainable research and portfolio construction process.
How Quantitative Valuation™ Compares to traditional value approaches.
Most managers and/or strategies rely on multiples that are insufficient and have no link to explaining a company’s value.
“Value” ratios such as P/E or P/B, or a mix of them, aka “cheapness ratios,” come with many shortcomings.
They rely on noisy accounting data.
- They rely on noisy accounting data.
- They look at a static point in time, assuming the world stays constant.
- Low multiple companies might mean they are in financial distress.
- They are commodity factors, available to everyone on Yahoo! Finance.
- Strategies are built using in-sample, rather than live, out-of-sample data.
Because of the deficiency of accounting-based valuation approaches, many managers have transitioned to using Discounted Cash Flow (DCF) models. A DCF is a cashflow based approach, however, the embedded assumptions and lack of practical application make them equally unreliable.
- Traditional discounted cash flow approaches tend to assume the status quo for a firm will persist forever.
- Perpetuity assumptions ignore the fact that companies will face competition.
- Such models are highly sensitive to changes in discount rates or growth rates, leading to drastic variance in values.
- Up to 70% of NPV of estimated cashflows typically come from perpetuity assumptions.
- Growth, risk, and competition estimates are subjective and inconsistent from one analyst to another.
- Insufficient live, out-of-sample valuation data, to assess process, skills and/or results.
Quantitative Valuation™ links together a series of proprietary innovations for research and portfolio construction across our firm.
Economic Margin® – Measures how well corporate management teams run their business. We analyze a company’s ability to generate cash-flows relative to their cost of capital and whether those cash-flows are allocated in a manner that increases or decreases shareholder wealth. Applied Finance’s Economic Margin® does this by correcting for GAAP accounting distortions and assigning company risk to gain a complete and standardized view of a company’s underlying economic performance that can be compared over time, firms, and across industries.
Economic Margin Valuation® – Links corporate performance to valuation and avoids the problems with traditional DCF models by explicitly modeling the effects of competition through company-specific Economic Profit Horizon™ estimates. Each week we systematically perform 20,000 valuations, over 20 million since our founding.
Intrinsic Value Factor™ – Ranks the attractiveness of over 20,000 companies worldwide us to understand how well we value the stocks we own in our portfolios and just as importantly those we do not so we continually learn and grow our knowledge base.
Valuation Driven Investing® – The design and implantation of investment strategies through a time-tested, consistent valuation approach.
Quantitative Valuation™ Edge
By properly understanding the intrinsic value of a company, Applied Finance reaches decisions distinctly different from value, growth, and passive investors providing us a repeatable and sustainable edge to generate alpha.
APPLIED FINANCE VS. VALUE MANAGERS
Value investors in aggregate consistently buy “cheap” companies, hoping these companies are also undervalued. Valuation is distinctly different from multiples. Price multiples try to indirectly identify stocks trading below their intrinsic value, i.e., the “Value factor.” Because Applied Finance directly calculates intrinsic value, we would expect price multiples with stronger correlations to our Intrinsic Value Factor ™ to perform better. However, when decomposing low multiple “cheap” vs undervalued stocks, it quickly shows “value traps” are common.
Risk Adjusted Returns: Intrinsic Value Factor vs Value
6 Portfolios formed on Size and Book to Price and Size and Applied Finance Intrinsic Value Factor. Point-in-time factor construction with monthly rebalancing from October 1998 to June 2020. Cap-weighted returns.
Notice the vast majority of alpha for value investors results from “cheap” stocks that are also undervalued according to Applied Finance.
“Cheap” stocks that are not supported by valuation, offer no traceable alpha. Conversely undervalued stocks deliver alpha regardless of if they are high or low price-to-book companies. We buy undervalued high multiple stocks from value investors and sell them overvalued low multiple stocks.
APPLIED FINANCE VS. GROWTH MANAGERS
Growth investors in aggregate consistently buy companies exhibiting superior sales or earnings growth characteristics, regardless of whether such companies are undervalued or creating shareholder value.
Risk Adjusted Returns: Intrinsic Value Factor vs Growth
6 Portfolios formed on Size and Growth Composite (5 Year Historical Sales and Size and Applied Finance Intrinsic Value Factor.
Point-in-time factor construction with monthly rebalancing from October 1998 to June 2020. Cap-weighted returns.
In aggregate, high growth companies underperform the market. Applied Finance is able to identify those higher sales growth companies that exhibit attractive valuation attributes, or undervalued securities, while selling those high growth stocks to growth managers that are overvalued.
It is only when you overlay Applied Finance Valuation that you can identify those growth opportunities trading at a discount to their intrinsic value.
APPLIED FINANCE VS. PASSIVE INVESTORS
Passive investors in aggregate consistently buy companies in proportion to their market capitalization regardless of whether they are over or undervalued, creating or destroying shareholder value. These investors consistently over-invest in overvalued companies and under-invest in undervalued companies.
The data below provides a strong and compelling case for finding a skilled manager that can consistently find and invest in undervalued securities while avoiding overvalued securities. We sell passive investors overvalued stocks in exchange for undervalued stocks.
Risk Adjusted Returns: Intrinsic Value Factor vs Market
6 Portfolios formed on Size and Applied Finance Intrinsic Value Factor. Point-in-time factor construction with monthly rebalancing from October 1998 to June 2020. Cap-weighted returns.
APPLIED FINANCE: VALUATION BETA ASSET PRICING MODEL
Factor investors ignore valuation-based factors that better explain cross-sectional stock dispersion. Traditional smart beta / factor-based strategies that overlook valuation are incomplete. Allocation towards the Intrinsic Value Factor provides a source of alpha overlooked by most factor investors.
Aggregate residual alpha and adjusted r-squared characteristics of 700 portfolios formed on 5×5 combinations of SMB, HML, RMW, CMA, UMD, VMC, RMD, and DME, October 1998 to June 2020
Valuation Beta – Replaces the current paradigm of relying on book to price as is common among the various Fama/French factor models used by DFA and the AQR Six Factor Model. This study introduces a new paradigm in asset pricing based on the application of a valuation-based asset pricing model, as opposed to a price multiple.
AF 5 FACTOR MODEL – Valuation Beta: SSRN Link (ID: 3713457)
The Applied Finance Quantitative Valuation™ methodology provides the foundation for an objective, repeatable, and sustainable investment process.
Learn about our Valuation Driven™ investment strategies.