The Piotroski F-Score aims to identify the healthiest companies amongst a basket of value stocks through applying a set of nine accounting-based stock selection criteria.
Background to the F-Score
Joseph Piotroski is now associate professor of accounting at the Stanford University Graduate School of Business. He developed the F-Score back in 2000 while at the University of Chicago. Piotroski recognized that, although it has long been shown that value stocks (or high book-to-market firms as he calls them) have strong returns as a group, there is nevertheless very wide variability in terms of the returns of these stocks. He noted that: “Embedded in that mix of companies, you have some that are just stellar. Their performance turns around. People become optimistic about the stock, and it really takes off [but] half of the firms languish; they continue to perform poorly and eventually de-list or enter bankruptcy.”
What he wondered was whether it was possible to weed out the poor performers and identify the winners in advance. He therefore sought to develop a simple accounting-based stock selection strategy for evaluating a stock’s financial strength. Piotroski's F-Score involves nine variables from a company’s financial statements. One point is awarded for each test that a stock passes. Piotroski regards any stocks that scored eight or nine points as being the strongest.
Does the F-Score work?
Empirical analysis to test out the strategy in the UK market seems to be very limited. However, Piotroski’s research in the US does suggest that this type of fundamental analysis can be an effective value filter. By investing in the top performers, he showed that, over a 20-year test period from 1976 through 1996 that “the mean return earned by a high book-to-market investor can be increased by at least 7.5% annually”. Furthermore, he found that buying the top stocks in the market and shorting those that got the worst scores would have resulted in 23% annualized gains, more than double the S&P 500 broad market index return. Piotroski also found that weak stocks, scoring two points or less, were five times more likely to either go bankrupt or delist due to financial problems.
More recently, the American Association of Individual Investors revealed that the F Score was the only one of its 56 screening methodologies that had positive results in 2008 (up 32.6% on average across 5 stocks, versus -41.7% for all of the AAII strategies over the same period).
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Calculation / Definition of F-Score
Piotroski's approach essentially looks for companies that are profit-making, have improving margins, don't employ any accounting tricks and have strengthening balance sheets. The nine variables are split into three groups:
A. Profitability Signals
1. Net Income – Score 1 if there is positive net income in the current year.
2. Operating Cash Flow – Score 1 if there is positive cashflow from operations in the current year.
3. Return on Assets – Score 1 if the ROA is higher in the current period compared to the previous year.
4. Quality of Earnings – Score 1 if the cash flow from operations exceeds net income before extraordinary items.
B. Leverage, Liquidity and Source of Funds
5. Decrease in leverage – Score 1 if there is a lower ratio of long term debt to in the current period compared value in the previous year .
6. Increase in liquidity – Score 1 if there is a higher current ratio this year compared to the previous year.
7. Absence of Dilution – Score 1 if the Firm did not issue new shares/equity in the preceding year.
C. Operating Efficiency
8. Score 1 if there is a higher gross margin compared to the previous year.
9. Asset Turnover – Score 1 if there is a higher asset turnover ratio year on year (as a measure of productivity).
- Piotroski noted that 1/6th of the return delta between strong and weak firms is earned over the four three-day periods surrounding subsequent earnings announcements, suggesting that the underlying cause is that the market is too slow to appreciate improved financial performance.
- He also made clear that the paper "does not purport to find the optimal set of financial ratios for evaluating the performance prospects of individual “value” firms" - rather, it is just one way that investors can use relevant historical information to eliminate firms with poor future prospects from a generic value portfolio.
Watch out for
- The Piotroski F-Score is not intended to be used on its own, but rather as an additional filter for a value screen. The starting point is taking the companies which fall into the bottom 20% of the market in terms of their price to book/NAV value.
- His paper also states that the “benefits to financial statement analysis are concentrated in small and medium-sized firms, companies with low share turnover, and firms with no analyst following”. The reason for this is presumed to be the information gap – there is less likely to be a genuine mispricing for large companies that have a lot of analysts.
From the Source
The original 2002 paper can be found here: Value Investing: The use of historical financial statement information to separate winners from losers. It is well, well worth the read.
Piotroski also notes that analysts do not typically recommend value stocks. His interesting explanation for this is that analysts are typically stock-pickers whereas, on an individual stock basis, the typical value firm will underperform the market and analysts probably recognize that a value strategy relies on purchasing a complete portfolio of stocks.
Useful Resources on Piotroski F-Score:
- Piotroski Profits - Forbes Article
- 2008 AAII Stock Screen Roundup: Piotroski Strategy Defeats the Bear
- An Accountant Looks at the Market - Chicago Booth Magazine
- Joseph Piotroski’s Stanford University Profile
- Wikipedia Article on Piotrowski
- Interactive Investor on Piotroski