This is designed by an accounting professor Joseph Piotroski at University of Chicago to evaluate a company’s financial strength. A “F score” is calculated for each company/stock by starting with a score of 0, then adding 1 to the score for each of the 9 criteria met. A score of 9 is the best.
- The research was specifically applied to low P/B firms. The average low P/B firm is financially distressed, so there is the implication that the firms in the research are financially distressed at some level.
- This distress is associated with declining and/or persistently low margins, profits, cash flows, and liquidity and rising and/or high levels of financial leverage. The 9 financial variables chosen reflect the changes in these economic conditions so as to predict future firm performance.
- The implication of financial distress also meant that some variables should impact one way rather than the other (e.g. financial leverage can be impact positively or negatively in general, but for financially distressed firms it should impact negatively).
- Strong stocks as a group outperformed a portfolio of all value stocks (low P/B) by 7.5% annually over a 20-year test period.
- If the expected winners (F score >= 5) were bought and expected losers (F score < 5) shorted between 1976 and 1996, it would result in a 23% annual return.
- From 1972 to 2001, average returns for U.S. firms with low F scores (0-3) is 7.3% p.a., medium F scores (4-6) is 15.5% p.a., and highest F scores (7-9) is 21% p.a. This compares with the market return of ~12.8% p.a.
- From 1985 to 2007, average returns for European firms with low F scores (0-3) is 4.4% p.a., medium F scores (4-6) is 13.1% p.a., and highest F scores (7-9) is 15% p.a. This compares with the market return of 12.5% p.a.
- Other Findings
- The F score worked best for small-medium sized firms, companies with low share turnover, and firms with no analyst following.
- Weak stocks (score <= 2) were 5x more likely to either go bankrupt or de-list due to financial problems.
- 1/6 of the annual return difference between strong and weak firms (according to F score) is earned over the 3 day periods (-1 day, the announcement day itself, +1 day) surrounding the 4 quarterly earnings announcements.
The 9 Criteria
- Return on assets: ROA > 0
- Change in return on assets: Change in ROA >0
- Cash flow from Operations: CFO > 0
- Accruals: CFO > ROA
- Leverage, Liquidity and Sources of Funds
- Leverage: Change in long-term debt to average total assets < 0
- Liquidity: Change in current ratio > 0
- Financing: Equity issuance < 0
- Operating Efficiency
- Margins: Change in gross margins > 0
- Asset turnover: Change in asset turnover > 0
- ROA = net income before extraordinary items / beginning of the year total assets
- CFO = cash flow from operations / beginning of the year total assets
- ROA > CFO is bad because a financially distressed firm with profits > cash flow from operations means that it is likely manipulating profits to prevent it from violating covenants.
- Equity issuance > 0 means the financially distressed firm requires external financing and signals its inability to generate sufficient internal funds. Raising equity is much worse than raising debt in this case because the stock prices of financially distressed firms are already depressed.
- Asset turnover = total sales / beginning of the year total assets
- This strategy requires basket diversification over thousands of companies. The large spread of returns for high F score firms exist with the median high F score firm (in terms of performance) underperforming the market. The overall performance is pulled up by the better half (~720 firms) of the high F score portfolio.
- The F score coupled with low P/B as per the research, is useful as an initial screen for further research.
- Market-adjusted return is the return less the buy-and-hold value-weighted market return (i.e. return from a market-cap weighted portfolio of all stocks).