Professor Piotroski decided to test his stock scanner to historical data, to compare the results vs. the ones reported for the period. This test finally resulted in what came to be known as Piotroski Score . The period in question was 1976 to 1996. It ended up giving 23% average return, annually. Validea reports, that by using a 20 stock portfolio size, that has ended giving 117.3% , bettering the market by 30.2%. Essentially, this score encompasses several accounting criteria with a binary score of 1 or 0. Each criterion, on fulfilling a condition is awarded either a 0 or a 1. A total of 9 points can be achieved. Stocks that clock scores between 0 and 2 are best weeded out of the portfolio. Stocks that score 7 to 9 are rated strong stocks.
Piotroski, a professor of accounts as part of his understanding the valuation of stocks wanted to understand if fundamental analysis had a role in selecting stocks. He shortlisted stocks with book/market ratios which were in the top 20%. He used their balance sheets and income statements; he used metrics like quality of earnings, leverage, operating cash flow etc. Eventually, he shortlisted 9 parameters under the heads of profitability, funding and efficiency, which was called F-score or the Piotroski score. A detailed understanding can be achieved by reading his paper Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers (2000) provide link to paper.
The Nine Parameters of Piotroski Score
Let us take a look at the nine parameters of Piotroski score:
Net Income: this is the total income of the company for the year – total expenses for year. Net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. Net income is often referred to as “the bottom line” since net income is listed at the bottom of the income statement.
Operating Cash Flow: A company generates revenue from its operations; this revenue minus taxes, interest paid, investment received and less dividend paid will give us the operating cash flow. A positive operating cash flow indicates the company has enough cash flow to fuel its growth.
Quality of Earnings: The portion of income a company earns thanks to its core activities rather than investments are called the quality of earnings. High quality earnings are a result of good sales and optimizing costs and usually recur over several reporting time frames. Investors look at this parameter to understand the source of income. High quality earnings are indicative of a thriving business with a good revenue model.
Return on Assets: A company’s annual earnings divided by the total assets will give us the Return of Assets or ROA. This parameter shows if the assets of the company are being employed effectively to generate income. That is assets are not being under-used , but optimally used. It is important that when we do comparative analysis of the ROA, it should be done, depending on the industry. Different industries have different ROA percentages.
Leverage: The ratio of a company’s loan capital (debt) to the value of its ordinary shares (equity) is known as leverage or gearing. Higher leverage is indicative of higher debt to fund operations. Conversely very low leverage indicates, assets could be put to better use.
Current Ratio: The ratio of current assets to current liabilities is known as current ratios. Does a company have enough resources to meet its short-tem and long-term liabilities? The current ratio helps answer that. The current ratio tells the investor if the company has market liquidity and is in a position to adequately meet creditor demands.
Outstanding Shares: The shares held by investors, who thereby have rights and ownership in the corporation are called outstanding shares. Often, companies will issue shares, thus diluting the ownership stake of existing investors. Once again, comparing to industry standards help. It also reveals the nature of ownership, where majority of the stake lies and so on.
Gross Margin: The difference between revenue and the cost of goods sold, divided by revenue, and the percentage thereof is known as Gross Margin. Margins represent a key factor in pricing, return on marketing spending, earnings forecasts, and analyses of customer profitability. (Source: Wikipedia)
Asset Turnover Ratio: Total asset turnover ratio measures how much revenue a company generates from every dollar of the total assets. A high asset turnover ratio indicates greater efficiency. A low asset turnover ratio indicates inefficiency, or high capital-intensive nature of the business. A low fixed asset turnover ratio could also mean that the company’s assets are new (less depreciation). For more information on this you can go to http://financetrain.com/fixed-asset-and-total-asset-turnover-ratio/
The following infographic explains the scoring of nine parameters in the Piotroski score calculation.