This simple quality ratio improves your returns.
This simple quality ratio improves your returns.
Rating a company's financial health - the easy way.
Hi Everyone,
I'm always amazed at how investors go by narratives rather than timeless rules. The most frequent question I get asked is: "Which stocks should I buy?” I think it's the wrong approach. The right one would be: "What characteristics do stocks have that minimize my risk of loss and increase my chances of profit?". Historically, there are dozens of factors to look for that answer that very question and help you outperform the market. Today, I would like to introduce you to one of those factors.
There are two basic factors to consider when selecting a stock: The financial health of the company and the valuation. While the former tells you if a company is investable at all, the latter tells you if it’s cheap in relation to what you get for each dollar invested. A company can be as cheap as you like, but if its quality is poor, you run the risk of betting on a sick horse. On the other hand, if a company is flourishing, but is temporarily sold off due to market sentiment, then your chances for outperformance are high. Always keep that in mind when reading about “cheap” stocks.
What if there was a comprehensive score that determined the financial health of a company?
Twenty-two years ago, Joseph Piotroski, an accounting professor at the University of Chicago, developed a formula for scoring a company and determining its overall financial strength. In the year 2000, the Piotroski F-score was first released.
The stocks are graded on a scale of 0 to 9, with 9 being the best. Each criterion that is satisfied earns the firm one point; if it is not met, no points are granted. The points are then combined together to find the top value stocks. According to Piotroski, a company's financial strength may be judged merely by data from its financial accounts.
Although the score considers various aspects, readers should be aware that the score is based on recent performance and identifies the current outperformer in terms of profitability and financial progress relative to its past. As a result, the score favors lately attractive performers over steady performers.
Here are the criteria:
Profitability
Positive net income compared to last year.
Positive operating cash flow in the current year.
Higher return on assets (ROA) in the current period compared to the ROA in the previous year.
Cash flow from operations greater than Net Income.
The health of the balance sheet
Lower ratio of long-term debt in the current period compared to the 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.
How did the performance improve?
Here’s the quote directly from the paper:
“The mean return earned by a high book-to-market investor can be increased by at least 7.5% annually through the selection of financially strong high book-to-market firms, while the entire distribution of realized returns is shifted to the right. In addition, an investment strategy that buys expected winners and shorts expected losers generates a 23% annual return between 1976 and 1996, and the strategy appears to be robust across time and to controls for alternative investment strategies.”
Where can I find this ratio when I’m looking for a specific stock?
While most screeners require payment, I found a source that’s free to use:
You just enter the stock that you want to look up and find the F-Score under “Health”.
And since I also have some readers from India, here is a source for Indian Stocks:
You will find the rating on the right side of each column.
How do I use this tool?
First of all, I am aware that backtests are rarely replicable, but they don't need to be. Such ratios serve as orientation and backtests rather show whether something works or not. To what degree a ratio works also often depends on factors that we cannot calculate. And this is where the big advantage lies. Successful investing is based more on making few mistakes than on doing everything right. And such a ratio serves as an excellent warning and orientation with a historically proven performance that clearly shows that companies with a high F-score have a higher quality and outperform, while those with a low F-score are poorly positioned.
Personally, I keep my hands off companies that score less than 5 points, but I keep them on my watchlist if they meet other criteria of mine, to see how they develop. Also keep in mind that this is a quality ratio, not a valuation ratio. It’s tells you if a stock is investable but not if it’s cheap.
Hope you learned something, until the next issue. 👋