The Piotroski Score is a financial scoring system created by Joseph D. Piotroski, an accounting professor, to identify the strongest value stocks based on specific financial criteria. The score ranges from 0 to 9 and is determined by evaluating nine fundamental signals that fall into three categories: profitability, leverage/liquidity, and operating efficiency. Each signal is binary (either 1 or 0), indicating whether a company meets a specific criterion.
The Nine Criteria of the Piotroski Score
Profitability Criteria (0 to 4 points)
- Net Income: Positive net income in the current year.
- Score 1 if positive, otherwise 0.
- Return on Assets (ROA): Positive ROA in the current year.
- Score 1 if positive, otherwise 0.
- Operating Cash Flow: Positive cash flow from operations in the current year.
- Score 1 if positive, otherwise 0.
- Quality of Earnings: Operating cash flow exceeds net income.
- Score 1 if operating cash flow > net income, otherwise 0.
Leverage, Liquidity, and Source of Funds Criteria (0 to 3 points)
- Decrease in Leverage: Lower ratio of long-term debt to total assets compared to the previous year.
- Score 1 if the ratio has decreased, otherwise 0.
- Increase in Current Ratio: Higher current ratio (current assets divided by current liabilities) compared to the previous year.
- Score 1 if the current ratio has increased, otherwise 0.
- No New Shares: No issuance of new shares in the previous year (indicating no dilution of shareholder value).
- Score 1 if no new shares issued, otherwise 0.
Operating Efficiency Criteria (0 to 2 points)
- Improvement in Gross Margin: Higher gross margin compared to the previous year.
- Score 1 if the gross margin has increased, otherwise 0.
- Improvement in Asset Turnover: Higher asset turnover ratio compared to the previous year (indicating more efficient use of assets).
- Score 1 if the asset turnover ratio has increased, otherwise 0.
Interpreting the Piotroski Score
- 8-9: Strong financial position, likely a good value stock.
- 5-7: Average financial health.
- 0-4: Weak financial position, potentially high-risk.
Calculation Example
Consider a hypothetical company with the following financial changes over the past year:
- Net Income: Positive (Score: 1)
- Return on Assets: Positive (Score: 1)
- Operating Cash Flow: Positive (Score: 1)
- Quality of Earnings: Operating cash flow > Net income (Score: 1)
- Decrease in Leverage: Lower long-term debt to total assets ratio (Score: 1)
- Increase in Current Ratio: Higher current ratio (Score: 1)
- No New Shares Issued: No new shares (Score: 1)
- Improvement in Gross Margin: Increased gross margin (Score: 1)
- Improvement in Asset Turnover: Decreased asset turnover ratio (Score: 0)
The Piotroski Score for this company would be 1 + 1 + 1 + 1 + 1 + 1 + 1 + 1 + 0 = 8.
Applications
- Value Investing: Helps investors identify undervalued stocks with strong fundamentals.
- Screening Tool: Can be used to filter out financially weak companies from a larger set of potential investment opportunities.
- Risk Management: Assists in assessing the financial health of companies, thereby managing investment risk.
Limitations
- Backward-Looking: Relies on historical financial data, which may not always predict future performance.
- Market Conditions: May not account for broader market or economic conditions that could impact a company’s financial health.
- Simplification: While useful, it simplifies financial analysis and may overlook qualitative factors or more nuanced financial metrics.
The Piotroski Score is a practical tool for value investors seeking to enhance their decision-making process by focusing on companies with solid financial foundations.