At a time when the outlook for many firms is deeply uncertain, how can you know the difference between a business in decline and one that’s on a solid footing?
For investors, the fact is that some apparently broken companies can, and do, come roaring back to life. Meanwhile, others with seemingly no obvious problems can suddenly find themselves in terminal decline.
What’s needed is a financial health checklist that can detect some of the important signs of strong and improving financial health. And that’s where something called the Piotroski F-Score can help...
In search of solid fundamentals
Long time Stockopedia users will know that we’re big fans of the F-Score (it features prominently on Stock Reports and in the Guru Screens and is a major contributor to the QualityRank).
It was first introduced in 2000 in a research paper by an accounting professor called Joseph Piotroski. His initial aim was to understand which stocks at the very cheapest end of the market were best placed to recover (and you can find the screen for that here). But his methodology was quickly picked up and applied as a general rule-of-thumb for finding high quality shares anywhere in the market.
Piotroski had created a nine-point accounting checklist - the higher the score out of nine, the better the financial health trend of the stock. Importantly, it was designed to look back over a company’s previous accounts and detect the most important clues to improvement or deterioration.
The nine checks are spread between three key areas of financial analysis. The first is profitability, where the F-Score looks at operating profits and cash flow to see if the business can sustain itself and even pay dividends. These checks look for an improving trend in profitability, which can be a sign that a turnaround is underway in underpriced and potentially misunderstood shares.
Three of the nine F-Score checks assess the capital structure of the business. These look for potential red flags over the health of the balance sheet. They assess whether the company is improving its capacity to service both long and short term debt, or if it is having to fund operations by issuing more shares.
Finally, the F-Score looks at whether the firm’s operating efficiency is improving by looking for improvements in gross margins and asset turnover.
A checklist for any occasion
In his own studies, which…
