The Piotroski F-Score Test is a value investing management tool to identify stocks of companies with good fundamentals and eliminate stocks of weak companies. The goal is to avoid value traps and only invest in real value stocks.
Value stocks are often values because the companies have encountered a challenge. Some companies will have the ability to overcome those challenges and others will not.
Piotroski developed a 9 point F-score ranking system that has produced an incredible performance record of finding quality investments. The American Association of Individual Investors (AAII) calculates a performance history of over 25% per year from 1998 – 2012 for the strategy.
The F-Score Test examines 9 tests in 3 areas: profitability, capital structure, and operating efficiency. Each test is given either 0 points for a fail or 1 point for a pass. All 9 tests can be derived from company financial statements.
Piotroski found that companies with 8 or 9 total points greatly improved the probability that the company had the ability to overcome challenges and eventually grow its stock price. Here are the 9 tests in the 3 areas:
9 F-Score Tests in Three Areas
1. Return on Assets
Return on assets (ROA) is net income before extraordinary items divided by assets. If ROA is positive award 1 point; if negative, no points.
2. Cash Flow from Operations
Operating cash flow is the cash flow excluding cash from financing and investing activities. This is one of the most important statistics available to an investor. One point is awarded for positive cash flow from operations and none if it is negative.
3. Direction of Return on Assets
Did the return on assets increase this year over last year? Is so, award 1 point; if not, no points.
4. Accrual – Compare Return on Assets and Cash Flow
Piotroski compared profit divided by assets (ROA) to cash flow divided by assets. Cash flow should be higher than ROA for 1 point, 0 points if it is not.
5. Direction of Leverage
Did the long term debt to assets ratio increase or decrease from the year before? If leverage decreased award 1 point; if it increased, no points.
6. Direction of Liquidity
Did the current ratio (assets divided by liabilities) increase or decrease from the prior year? If it increased, award 1 point; if it decreased, no points.
7. Issue Stock
When a company issues stock it dilutes the present shareholders stake and may be a sign the company is unable to raise sufficient capital from operations. If the company has not issued stock in the past year award 1 point; if it issued stock, 0 points.
8. Direction of Margin
If the gross margin ratio has increased (year over year) that is a positive sign, award 1 point. Falling margins would be a warning sign, no points awarded.
9. Direction of Asset Turnover
An increase in asset turnover (sales divided by assets at the beginning of the year) from one year to another would indicate greater efficiency. Award 1 point for a higher asset turnover ratio than the previous year; 0 points if it has decreased.
Portfolio Management Tool Box
There is no single magic formula that will give you a certain answer to whether you have chosen the right stock. In fact when any strategy becomes well known, it will become less successful as more investors take advantage of stock market inefficiencies.
However, it is clear to me that the the Piotroski F-Score Test is a value investing strategy that should be part of your portfolio management tool box. Use it to augment your stock selection skills and increase your probability of successful investment outcomes.
Related Reading: Value Trap or Real Value Stock?