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How to Invest: The Piotroski Score

By  +Follow January 9, 2014 9:00AM
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This investment strategy comes from Joseph Piotroski, an accounting professor at the University of Chicago, who developed this method for weeding out quality stocks in 2000.

Piotroski developed his score after noting that, while P/B ratios (price/total assets- intangible assets and liabilities) were often an excellent method for identifying undervalued companies, a low P/B could also indicate a company in trouble.

Embedded in that mix of companies, you have some that are just stellar," he said. "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.”

The Piotroski Score

Also known as the Piotroski F-Score, Piotroski developed a nine-step criteria to evaluate any company with strong P/B ratios. The result was a 0-9 score. Any companies scoring an 8 or 9 is strong, while 0-2 is weak. When he developed this method in his 2000 paper, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, Piotroski observed that, when doing historical research on the method, it would have brought 23 percent returns from 1976-1996.

What's more, since 1998, stocks with a high Piotroski F-Score have produced annualized returns of 22.5 percent, with 2010 representing the best year with a 138.8-percent return, and 2008 marking the worst with a loss of over 35 percent.

The nine criteria for the Piotroski score represents a series of "yes" or "no" questions about a company in three categories: Profitability; Leverage, Liquidity, and Source of Funds; and Operating Efficiency. For every "yes", add one to the score. The nine criteria are as follows:

Profitability

  • Positive return on assets in the current year.
  • Positive operating cash flow in the current year.
  • Higher return on assets or ROA in the current period compared to the ROA in the previous year.
  • Cash flow from operations are greater than ROA.

Leverage, Liquidity and Source of Funds

  • Lower ratio of long term debt to in the current period compared value in the previous year.
  • Higher current ratio this year compared to the previous year.
  • No new shares were issued in the last year.

Operating Efficiency

  • A higher gross margin compared to the previous year.
  • A higher asset turnover ratio compared to the previous year.

Value Investing with a Focus

Price-to-book ratio was a favorite of legendary value investor Benjamin Graham, one of the primary influences on men like Warren Buffett, but it's notoriously inconsistent in identifying value. However, Piotroski's scoring method designs a way to figure out which companies have a low P/B because they're undervalued and which ones have fundamental problems. Like any method developed from historical data, a Piotroski score can be inconsistent.

Past results don't always translate to future returns, and the very fact that Piotroski's method has been adopted by many investors will have its own effect on the market, but the Piotroski Score does still provide another way of valuing stocks.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.


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By  +Follow January 9, 2014 9:00AM
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