Introduced and published in ‘Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers’ by Joseph Piotroski, an Accounting professor at the University of Chicago, the Piotroski F-Score is an indicator with a scale between 0 (zero) and 9 (nine) which can be used to determine the financial strength of a company.
In his paper, he demonstrated that awarding points for specific figures in a company's current and previous year financial statements can lead to insightful results on its value. Backtesting his method over a two-decade period between 1976 and 1996, through buying expected winners while shorting low scoring stocks, saw a 23% average annual return.
While past results are no guarantee for future results, his method is something to consider when assessing a companies’ current financial position.
The 9 Criteria of the F-Score
The 9 criteria listed can be categorized into 3 major groups. The following section will examine each of the groups and outline the requirements for a point.
The first point is awarded if the company has a positive Return on Assets (ROA) in the current year. The Return on Assets is calculated by dividing the Net Income by Total Assets.
ROA = Net Income / Total Assets
Since financial engineering can adjust the Return on Assets, Piotroski introduced his second criteria based on Operating Cash Flow. The company gets a point if the operating cash flow is positive.
The third criterion is introducing the first comparison of the results of the previous year. A point is awarded if the Change in Return of Assets is positive. The change is calculated by subtracting last year’s ROA from this year’s ROA.
Change in ROA = ROA (this year) - ROA (last year)
The final point to evaluate profitability is the quality of earnings measured by Accrual. If the company's cash flow from operations divided by total assets is higher than the ROA a point is awarded.
Leverage, Liquidity, and Funding (5-7)
The first point in this section is awarded if the long term debt to equity ratio is lower than in the previous year. You can calculate the ratio by dividing long-term debt by total assets. A company can achieve this by either raising its total assets or paying down long-term debts.
Furthermore, a company can be awarded another point in this section by increasing its current ratio compared to the previous year. The current ratio is calculated by dividing total current assets by total current liabilities. This helps investors judge the liquidity of the company by showcasing whether the company has enough liquid assets to cover short-term liabilities.
A general rule of thumb is that the current ratio of 2.0 showcases a stable financial position in which a company has sufficient working capital to meet short term obligations. But take this rule with a grain of salt as it can differ across industries.
The final point for this category is awarded if the absolute number of outstanding shares is lower than in the previous year.
Operating Efficiency (8,9)
This section covers operating efficiency by evaluating the change in gross margin and asset turnover. A point is awarded if each of the factors is higher than in the previous year. The following formulas can be used to calculate each of the values:
Gross Margin = Net Sales / Cost of goods sold
Asset Turnover = Revenue / Average Total Assets
Before taking the score at face-value when analyzing a company you may want to consider its limitations and how they may apply to the stock and industry you’re interested in.
First, I want to point out that the score only covers recent history by reflecting on the results of the past two years. This means commodity prices and the cyclical nature of some stocks can lead to very high volatility of the score. Take the oil prices of 2020 as an example and you will see that none of the major oil companies score a higher score than 5.
To mitigate the limitation I would never take the score out of context. Comparing one company’s score to other players in the same sector will draw a better picture of the overall environment.
Another limitation is that the score uses mainly ratios in comparison to the previous year without considering their face value. Taking the current ratio as one example, a company can be awarded a point if it is better than its previous year, but that does not necessarily mean that a company is in a good place to cover short term liabilities - just in a better position than they were last year… but how much better?
Finally, implementing a strategy around this score can be quite difficult for individual investors, as the value can be calculated (and is subject to change) each quarter. If you wanted to only hold positions with 8 or 9 out of 9 scores, you could see a lot of turnover in your portfolio.
I was unable to find an ETF that would give you access to a strategy based on this score. Up to date benchmarking can be done but you will need access to premium screeners and backtest tools.
Using Yahoo Finance to determine the Score
The following example will showcase how to calculate the Piotroski F-Score of Apple (NASDAQ: AAPL) using Yahoo Finance.
Using the portal you will find all the information you need in the Financial Section of a stock. The Balance Sheet, Income Statement, and Cash Flow tab will give you access to historical values.
Now, without further ado, let’s jump into the calculation:
Using the Net Income from the Income Statement we can find that Apple’s net income was positive (57,411,000) and therefore we award the first point.
Current Score: 1
Using the Operating Cash Flow found in the Cash Flow tab, we’re able to determine that Apple’s Operating Cash Flow is positive (80,674,000).
Current Score: 2
Calculating the change on return on assets ( Net Income (Income Statement) / Total Assets (Balance Sheet), we’re able to determine that the ROA 2019 is higher than the ROA 2018.
Current Score: 3
Judging the accrual by comparing Operating Cash Flow (80,674,000) to Net Income (57,411,000), we can see that Apple is awarded 4 out 4 points in the profitability category.
Current Score: 4
When calculating the Leverage ratio ( Long Term Debt / Total Assets) we can see that the ratio declined between 2019 and 2020, and therefore we won’t be able to award a point.
Current Score: 4
A similar result can be seen when calculating the current ratio by dividing Current Assets by Current Liabilities (both in the Balance Sheet tab). As last year’s current ratio is higher Apple will not be awarded a point.
Current Score: 4
The final point of this section compares the number of shares issued to the number of last years. Here we can see that the number decreased from 17,772,944 (2019) to 16,976,763 (2020) and a point is awarded.
Current Score: 5
Using the Income Statement we can determine the efficiency. Calculating the Gross Margin we can see that the margins have improved year over year and can add a point to the score.
Current Score: 6
As a final step, we will calculate the asset turnover of 2020 and 2019 by dividing Revenue (Income Statement) by Total Assets (Balance Sheet) and determine that the turnover is higher. Therefore we can award a final point.
Final Score: 7
All in all, we can see that Apple scores a 7 out of 9 in the Piotroski F-Score, and based on this most would conclude that it is in a good financial position. Year over year, the company has a slightly higher Leverage and less Liquidity but is in a great spot otherwise (whether it’s absolute or relative to the previous year).
Thanks for reading through this introduction into the Piotroski F-Score as a quick metric to gain insight into the financial health of a company by comparing year over year numbers.
I would love to hear if this article was helpful for you and which models and scores you’re using when evaluating a company's financial position as well as the fair stock price.
This article expresses personal opinions and observations of someone who is not licensed to provide financial advice. I am not receiving compensation for writing this blog post.
I do hold a position in Apple Inc. (NASDAQ: AAPL), which is mentioned in this article.