Joseph Piotroski is a professor of accounting at the University of Chicago Graduate School of Business. In 2000, he published a paper detailing a method which he developed for analyzing the inherently riskier value stocks on the market. In this paper, he also discusses the result of an extensive study of 14,043 companies tracked over a 20 year test period between 1976 and 1996 to show the efficacy of his method.
Piotroski’s F-score method provides investors with an elegantly simple yet thorough equation for calculating the strength of a company based entirely on information available in its financial records. It examines nine components across three different areas which Piotroski identifies as the most important indicators of a company’s financial strength.
In order to simplify the process, he uses a binary scoring system meaning each component is assigned a score of 1 if it meets Piotroski’s criteria or 0 if it does not. The scores of all nine components are then added together to provide the F-score which will land somewhere between 0 and 9.
The idea is that the higher a company’s F-score, the more likely the stock will be to bring a return to investors. Stocks with F-scores of 8 or 9 then, would be expected to bring about the highest returns on investments. But before we look at whether or not this holds up in reality, let’s take a closer look at the components Piotroski uses in his evaluations.
The three financial areas evaluated to determine a company’s F-score are profitability, financial leverage and liquidity, and operating efficiency. It is thought that together, these three areas provide a rounded picture of a company’s financial strength and ability to persist through or recover from economic hardships. Each of the nine components specifically analyzed fall within one of these three areas.
In Piotroski’s paper, the results of his method are definitely impressive. It bears mentioning that its success when applied to past cases does not necessarily mean that it will continue to be as successful in the future. However, the consistency of positive results seen in the test sample show that it is very promising and likely to be a useful method for investors with value stock portfolios. That said, let’s take a closer look at how useful a stock’s F-score was in determining its success:
Included in the sample set of 14,043 companies are stocks with F-scores spanning the whole range from 0 to 9. Most stocks had a score landing between 3 and 7. However, the 1,448 stocks with an F-score of 8 or 9 invariably saw consistent returns on investment. On the other end of the spectrum, the 396 stocks with scores of 0 or 1 consistently saw poor returns and were five times more likely to have gone bankrupt or to have been delisted due to financial problems.
This means that at the extreme ends of the spectrum, Piotroski’s method definitely holds up. Furthermore, the difference in rates of return on high F-score stocks and those with low F-scores are substantial. Those receiving a score of 8 or 9 outperformed their weaker counterparts by an average of 15.2%. Value stock portfolios containing exclusively high-scoring stocks (with scores of 8 or 9) saw average annual returns 7.5% higher than the returns on value stock portfolios containing a mixture of both high and low scoring stocks. The better performance of high-scoring stock portfolios was consistent over the course of the 20 year test period.