Since its debut in 1968, the Altman Z-Score has been followed religiously by analysts worldwide due to its ease of calculation and relative accuracy at predicting bankruptcies (72% in its initial test). Here at Stockopedia we like to base our indicators on the original research papers that identified these tools, however it has been known for many years that the Z-score has its limitations.
Part of the reason for this is that it was originally developed for the analysis of operating industrial companies. It can therefore struggle with some negative working capital companies and financial companies, as discussed in our help item here. As a result we’re always on the lookout for any improvements that give the investor a better view on which companies to avoid and why (or indeed which companies to actively short and why).
In this mini-series of blog posts we’ll look at some of the main contenders for Z-Score replacement and review their use in the current market, you may even see some of them in a future screen. Contenders include the Ohlson O-score, Merton's 'distance-to-default' method and the one we'll discuss today, the as yet unnamed Campbell-Hilscher-Szilagy probability model (or CHS model for short).
CHS Model
The CHS model was developed by a Harvard team in 2010 with the aim of creating:
“a model of corporate failure in which accounting and market-based measures forecast the likelihood of future financial distress.”
The approach used is relatively simple and intuitive; the model scours the market for firms displaying recently made losses, high leverage, low and volatile recent returns, high levels of market to book and a low share price. While this may sound simple enough, through the use of more up to date statistical models and time based market variables the authors assert a substantial improvement over the aging Altman Z-score and the popular ‘Distance-to-Default’ model (see later blogs). They even calculate a 16% improvement on early 00’s research which had already boosted the forecasting power of the z-score through a streamlining of the variables. All this suggested to us that the CHS model is worth taking a closer look at so we’ll begin by examining the variables employed.
- Weighted Profitability Measure: This is the ratio between a company’s net income (losses) and the market value of their total assets. It is most likely to be negative for distressed firms and the formula gives greater influence…
