In this article I present AAII’s strategy that explores stocks with low share prices relative to their book value to see if it’s possible to establish basic financial criteria to separate the winners from the losers. The Piotroski financial scoring system has grown into a popular approach to identify companies that have solid and improving financials. Our Piotroski High F-Score screen segments firms by financial strength and is helpful in identifying both potentially attractive stocks as well as companies to avoid. Generally, the higher the F-Score, the greater the average portfolio return.
Seeking Companies With High F-Scores
Joseph Piotroski, an accounting professor, set out to see if it was possible to use simple financial criteria to separate the winners from the losers among the universe of deep-value stocks. In his study, reported in the research paper “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers,” Piotroski noted strong evidence supporting the use of value multiples such as the price-to-book-value (P/B) ratio to build portfolios that outperform the market, but not all deep-value stocks turn out to be winners. Most academic researchers construct large portfolios that end up beating the market by holding a few big winners that overcome the many underperforming stocks in the portfolio.
Piotroski’s financial scoring system (F-Score) used nine criteria that he divided into broad categories:
- Profitability
- Capital structure—that is, leverage, liquidity and sources of funds
- Operating efficiency
Piotroski then scored each criterion with either a zero or a one, depending on a company’s underlying financials. Together, the nine criteria compose a composite F-Score that has a maximum score of nine; the higher the score, the better. In his study, Piotroski compared the performance of “winners” (a score of eight or nine) and “losers” (a score of zero or one). He found that the winners outperformed the losers over the following year.
The Piotroski screen has been one of AAII’s top-performing screens over our long-term comparison, but with a great deal of variability from year to year.
The Price-To-Book Ratio
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Stocks with a low share price relative to their book value is the starting universe for Piotroski. While the market does a good job of valuing securities in the long run, in the short run it can overreact to information and push prices away from their true value. Measures such as the price-to-book ratio help to identify which stocks may be truly undervalued and neglected.
The price-to-book ratio is determined by dividing market price per share by book value per share. Book value is generally determined by subtracting total liabilities from total assets and then dividing by the number of shares outstanding.
If accounting measures truly capture the value of a stock, then the stock should trade at a price near its accounting book value. However, this is typically not the case. Companies have some leeway when implementing accounting principles. While companies follow generally accepted accounting principles (GAAP), no two companies have the exact same accounting policies. The financial statements require many assumptions, judgments and estimates by management, which causes variations among firms even if management is not trying to distort or manipulate the numbers. Some firms are more conservative regarding how they report and track the values of revenues, costs, inventories, assets and even liabilities, while others are more aggressive. These decisions flow through the income statement and impact the book value of assets and liabilities.
Piotroski first limited his universe to the bottom 20% of stocks according to their price-to-book ratio, and this is our first screening criterion.
Financial Condition
Piotroski developed a nine-point scale that helps to identify stocks with solid and improving financials. Profitability, financial leverage, liquidity and operating efficiency are examined using popular ratios and basic financial elements that are easy to use and interpret. For this screen, a passing stock is required to have a score of eight or nine.
Minimum Profitability
Piotroski awarded up to four points for profitability: one for positive return on assets (ROA), one for positive cash flow from operations, one for an improvement in return on assets over the last year and one if cash flow from operations exceeds net income. These are simple tests that are easy to measure. Because the requirements are minimal, there is no need to worry about industry, market or time-specific comparisons.
Return on assets examines the return generated by the assets of the firm. Return on assets is net income divided by total assets. A high return on assets implies that the assets are productive and well-managed. If the firm’s return on assets is positive, the subsequent indicator for F-Score purposes is equal to one. If the firm’s return on assets is negative, the indicator will equal zero.
The second variable in the profitability criteria is operating cash flow. If the firm’s operating cash flow is positive, one point is scored. If it is negative, zero points are scored. Operating cash flow is reported on the statement of cash flows and is designed to measure a company’s ability to generate cash from day-to-day operations as it provides goods and services to its customers. Operating cash flow adjusts net income for items such as depreciation, changes to accounts receivable and changes in inventory.
The third metric, change in return on assets, is the current year’s return on assets less the prior year’s return on assets. A company can increase return on assets by boosting its profit margin or by using its assets to increase sales (or both). If the change in return on assets yields a positive number, one point will be awarded. Otherwise, zero points will be awarded.
The final metric in the profitability section of the F-Score calculation addresses the relationship between earnings and cash flow levels—accruals. Piotroski seeks companies with cash flow from operations greater than net income before extraordinary items. The measure tries to avoid firms making accounting adjustments to earnings in the short run that may weaken long-term profitability. Piotroski feels that this accrual relationship may be particularly important when evaluating value firms due to the possibility that management has a strong incentive to manage earnings to avoid triggering problems such as violations to debt covenants. If cash flow from operations is greater than net income before extraordinary items, the firm will receive one point for the accruals score, otherwise a zero is entered.
Capital Structure
Piotroski awards up to three points for capital structure and the firm’s ability to meet future debt obligations: one if the ratio of debt to total assets declined in the past year (change in leverage), one if the current ratio improved over the past year (change in liquidity) and one if the company did not issue any additional common stock (change in source of funds). Since many low price-to-book stocks are constrained financially, he assumes that an increase in financial leverage, a deterioration of liquidity or the use of external financing are signs of increased financial risk.
Piotroski measures change in leverage as the historical change in the ratio of total long-term debt to average total assets. For our purposes, we have also added in short-term debt to the numerator because many companies include the current portion of long-term debt in this figure. The higher the figure, the greater the financial risk. According to Piotroski’s research, by raising external capital, a financially distressed firm is signaling its inability to generate sufficient internal funds. In addition, an increase in long-term debt is likely to place additional constraints on a firm’s financial flexibility. If the firm’s leverage ratio didn’t change or fell in the most recent fiscal year compared to the prior year, the firm will receive one point. Otherwise, it receives zero points.
The variable change in liquidity measures the historical change in the firm’s current ratio between the current and prior fiscal year. The current ratio is defined as the ratio of current assets to current liabilities at fiscal year-end. A high current ratio indicates a high level of liquidity and less risk of financial trouble. Too high of a ratio may point to unnecessary investment in current assets, failure to collect receivables or bloated inventory—all factors that negatively affect earnings. Piotroski assumes that an improvement in liquidity is a good signal of the firm’s ability to service debt obligations. The liquidity variable equals one if the firm’s current ratio improved and is zero otherwise.
The final capital structure element awards one point if the firm did not issue common stock over the last year. Similar in concept to an increase in long-term debt, financially distressed companies that raise external capital could be indicating that they are unable to generate sufficient internal cash flow to meet their obligations. Additionally, if a company issues stock while its stock price is likely depressed (has a low price-to-book ratio), it highlights the company’s weak financial condition. We measure an equity offering by assessing if the company has maintained or reduced the average number of outstanding shares during its last fiscal year.
Operating Efficiency
The remaining two elements examine the changes in the efficiency of operations. Companies gain one point for showing an increase in their gross margin and another point if their asset turnover has increased over the last fiscal year. The ratios reflect two key elements impacting return on assets.
Long-term investors buy shares of a company with the expectation that the company will produce a growing future stream of cash from selling goods and services. Gross profit margins reflect the firm’s basic pricing decisions and its material costs. Gross income, or profit, is measured as revenue less the company’s cost of goods sold. Gross margin represents the proportion of each dollar of sales that the company retains as gross profit.
Piotroski feels that an improvement in gross margin signifies a potential improvement in factor costs, a reduction in inventory costs or a rise in the price of the firm’s product. The change in gross margin is defined as the firm’s current gross margin (gross income divided by total sales) less the prior year’s gross margin. If the company’s current gross margin is above that of last year, the firm will receive one point. Otherwise, a zero is logged.
The final element in Piotroski’s financial scoring system adds a point if asset turnover for the latest fiscal year is greater than the prior year’s turnover. Asset turnover (total sales divided by average total assets) measures how well the company’s assets have generated sales. An increase in the asset turnover signifies greater productivity from the asset base and possibly greater sales levels.
Our Piotroski High F-Score screening model has shown impressive long-term performance, with an average annual gain since 1998 of 14.9%, versus 5.7% for the S&P 500 index over the same period.
Stocks Passing the Piotroski High F-Score Screen (Ranked by F-Score and Lowest Price-to-Book Ratio)
The companies with the highest F-Score and lowest price-to-book ratio are shown in the passing companies table below.
The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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