Are your investments at risk? 3 useful Red Flags: Altman, Beneish and Piotroski

Monday, Feb 06 2012 by
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Are your investments at risk 3 useful Red Flags Altman Beneish and Piotroski

Warren Buffett’s rule #1 of investing is “Don’t Lose Money" while rule #2 is “Don’t forget rule #1.” As with most Buffet aphorisms, though, the devil is in the detail of implementation. Clearly, though, one important way to prevent yourself losing money is to avoid investing in fraudulent or financial weak companies.  While forensic accounting and detailed credit analysis may be beyond the ability of most individual investors, there are some excellent statistical short cuts that have been developed by professors of finance to highlight high-risk shares. Our research and reading in the area have uncovered the following 3 investing red flags that we think every sensible investor should try to understand in the context of their stock portfolio.

What's the Bankruptcy risk?

The Altman Z-Score has been a part of the investor toolkit for more than 40 years but is not as well-known as it should be. It was developed by New York University finance professor, Edward I. Altman, who used a combination offive weighted business ratios to estimate the likelihood of financial distress. It was initially created to test the financial health of manufacturing companies; with later tweaks opening it up to non-manufacturing and even private companies. Ultimately, any Z-Score above 2.99 is considered to be a safe company. Companies with a Z-Score < 1.8 have been shown to have at significant risk of financial distress within 2 years. Some investors may question the idea of using a formula to predict bankruptcy – and to be fair it does produce some surprising results – but nevertheless tests have proved it to be highly effective. Its initial test found that it was 72% accurate in predicting bankruptcy two years prior to the event, while subsequent examination has shown 80-90% accuracy.

What's the Earnings Manipulation Risk?

Glamour and growth are alluring not only to investors but also to company management whose compensation is dependent on a continuation of the trend. Accounting tricks such as booking sales early, changing depreciation rates and so on are all available for managers to massage earnings figure. The Beneish M-Score was developed to highlight these companies. An M-Score > 2.22 highlights companies that may be inflating their earnings artificially increasing the likelihood they will have to report lower earnings in the future.

In a similar vein, James Montier has developed a system called the C-Score

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>


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