Using The Piotroski Score To Spot Bargains

Value investing is a pretty straightforward concept, where investors aim to purchase underpriced securities to their advantage. Legendary investors such as Warren Buffett, Michael Larson, and Martin J. Whitman swear by this investment paradigm, derived from the ideas put forward by David Dodd and Benjamin Graham in the late 1920s.

But spotting bargains on the stock market is no easy task—millions of people look to do the same every day. That’s where the Piotroski Score comes into the picture. Created by Joseph D. Piotroski, the Piotroski Score is a simple accounting-based stock selection strategy that helps investors determine the financial health of a company. It was first introduced in an influential research paper titled ‘Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers’.

What The F-Score Does

When prospective investors decide to opt for the cheapest bets, they more often than not, end up with a large number of potential options, each of which can be considered a value stock. At such a time, comprehensively analyzing the fundamentals of each prospect can seem a little daunting.

Joseph Piotroski was interested in the cheapest 20% of the market (calculated by using the P/B ratio), which he believed consisted of the most undervalued stocks on the market. However, Piotroski also knew that 40% of the stocks in his selection would never turn out to be profitable. So, he devised a method to pick out the undervalued stocks that would most-likely turn a profit from those that would definitely wouldn’t.

Piotroski score vs S&P index

The Piotroski Score, as it later came it be known, is a discrete score between 0 and 9, which reflects the nine different criteria used to evaluate a company’s financial strength and position. For every criteria that is met, the stock is awarded one point. At the end of the analysis, the points are added up to determine the best value stocks.

Does The Piotroski Score Actually Work?

The Piotroski Score has built up a formidable reputation over the years as a screening methodology. Today, it is used as a key research tool by investment banks like Morgan Stanley and Societe Generale.

Joseph Piotroski’s intensive research on the American market between 1976 and 1996 unearthed some surprising results. Buying only those stocks with high Piotroski Scores and consistently short-selling the worst performers would have resulted in 23% annualized gains for investors; this was more than double the S&P 500 broad market index return for the same time period.

The American Association of Individual Investors reported that the Piotroski F-Score was one of the 56 screening methodologies which yielded positive results in 2008. According to Joseph Piotroski, weak stocks that scored less than 2 points were 5 times as likely to delist due to financial problems.

Breaking It Down

The Piotroski Score offers valuable insights for those looking at long-term investments. The nine variables used in the F-Score are split into 3 groups—profitability signals, operating efficiency, and leverage, liquidity and source of funds. Below is a list of these nine variables.

  1. Profitability Signals

Return on Assets If the company’s ROA is higher in the current quarter as opposed to the same quarter in the previous year, then one point needs to be added.

Operating Cash Flow - One point is to be added if the company reports positive cash flow from operations in that year.

Level of Earnings - Add one point if the current year’s operating cash flow exceeds the net income.

Net Income - If the company has a positive net income for that year, add one point.

  1. Leverage, Liquidity, and Source of Funds

Absence of Dilution - If the company did not issue new shares that year, then add one point.

Decreasing Leverage Level - Add one point if the company has a lower long-term debt-to-equity ratio in the current year as opposed to the last one.

Increasing Liquidity Level - One point is to be added if the company’s current ratio is higher this year as compared to the last one.

  1. Operating Efficiency

Asset Turnover - Add one point if the asset turnover ratio is more than what it was the previous year.

Gross Margin - If the gross margin was higher than last year, add one point.

As is the case with any investment strategy, the Piotroski Score is not foolproof. Joseph Piotroski himself said that his methodology does not claim to find the best set of financial ratios required for determining the prospects of individual firms; rather, it finds the best possible choices by eliminating weaker prospects from a generic value portfolio.

This screening methodology is to be used in conjunction with other research tools, as an additional filter. Even though it has independently delivered positive results in the past, it does not provide as comprehensive a pictures as some investors may want.

Where The Piotroski Score Falls Short

One of the issues with the F-Score is that it focuses solely on improvement, rather than gauging improvement margins. For instance, if a company’s gross profit margin is just 0.1% higher than what it was last year, it still gets to score. Likewise, a company’s debt-to-equity ratio may decrease by less than 1%, but it is awarded a point nevertheless. Consider this—a debt-to-equity ratio of 43% is huge, but still lower than say, the 46% from last year, effectively earning that company a point.

The F-Score is not amenable to contrarian investors, who often swim against the tide. Simply put, contrarian investors pick up stocks when the fundamentals of companies are in a trough. The F-Score can’t pinpoint such companies since it can only pick them out when their fundamentals are improving again.

The standardized time window over which stocks are evaluated may be too narrow in some cases. For example, a company’s operating cash flow may be lower than its net income in 1 year, but over the period of multiple years, the operating cash flow might definitely prove to be higher. It is imperative for prospective investors to consider such limitations before making any investments based on the F-Score. After all, quantitative tools can be a useful starting point, but aren’t necessarily an ending point.


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