No value investor wants their money to be dead for years. Ending up with value traps is a big problem. If only there was a way to avoid it? Enter Piotroski F-Score.
The Piotroski F-Score is a powerful, yet underutilized, tool that enhances your stock-picking strategy. Developed by Joseph Piotroski and published in his 2002 paper, this scoring method helps investors identify financially strong companies within the value universe. In this article, you’ll discover how the Piotroski F-Score works, why it matters, and how you can incorporate it into your investment process. By the end, you’ll have another edge in identifying hidden gems that the market often overlooks.
What is the Piotroski F-Score?
Piotroski F-score is simple scoring system designed to find financially strong companies. The scoring is based upon readily available historical financial data, as we will see in a little bit. The scores range from 0 to 9, with scores of 8 and 9 considered strong and scores below 2 considered weak. When you pair high Piotroski F-scores with other valuation metric, you can find strong value stocks that are unlikely to be value traps.
Piotroski found that high book to market stocks (low p/b ratio) when paired with high F-score (buy) and low F-score (short sell) adds another 7.5% in annual return compared to a simple market basket of high book to market stocks. This is a significant alpha to add to your portfolio.
How the Piotroski F-Score Works: 9-Point Checklist
Each metric scores either 1 (positive) or 0 (negative), giving a total score between 0 and 9.
Profitability Metrics (4 Points)
- Net Income: Is net income positive? This implies a profitable company. You get this from the income statement
- Operating Cash Flow: Is cash flow from operations positive? This shows that the company is generating cash from its main business. You get this from the Cash flow statement
- Return on Assets (ROA): Did ROA improve compared to the previous year? This shows that the company is making good use of its assets and improving its profitability. You get this from income statement (revenue) and balance sheet (asset) and then you compare this year’s ratio to the prior year to make sure it is increasing.
- Accruals: Is cash flow from operations greater than net income? (Indicates earnings quality. It means that the net income is not driven by the change in accruals, which is merely an accounting artifact. You will get these numbers from the cash flow statement and the income statement)
Leverage, Liquidity, and Source of Funds (3 Points)
- Change in Leverage: Has the company reduced its debt-to-equity ratio? This means company is getting less indebted. Get this from the balance sheet.
- Current Ratio: Did the company improve its current ratio? This means liquidity is getting better. Get this from the balance sheet.
- New Shares Issued: Has the company avoided issuing new shares? This means there is no share dilution. It is easy to improve leverage and liquidity by issuing new shares. We want companies that are doing this by strong execution in their operating business, not by equity financing. Get the shares outstanding from the balance sheet.
Operating Efficiency (2 Points)
- Gross Margin: Did gross margin increase year-over-year? This means the companies is achieving economies of scale/scope and/or getting better at improving pricing or reducing expenses in other ways. Get this from income statement.
- Asset Turnover: Is the company generating more revenue per asset? Similar to ROA, this implies the company is getting better use out of its assets. Get from the income statement and the balance sheet.
Why Use the Piotroski F-Score?
Piotroski F-score is a quick way to weed out value traps. There are many companies that look undervalued at the surface but there is a reason for it. Using this screen will eliminate those companies that have weak financials and may be running headfirst into a financial crisis.
Please note that not all high f-score stocks are good investments. They may all be quality companies, but you still need to screen for valuation to make sure you are not overpaying for the stock. Ideally you will pair the high f-score screen with a low P/E or low P/B filter, but of course you can choose any of your favorite valuation criteria. Professor Piotroski used the high book to market filter, which is another way of saying low P/B filter.
Not only there is empirical data showing the stocks with high Piotroski F-Scores outperform their peers, but F-scores are also relatively simple to calculate from publicly available financial metrics. This makes it a very easy and accessible way to analyze stocks. Ultimately, it is a checklist.
Interpreting the Score: What’s a Good F-Score?
Higher scores are better, and generally, scores of 8 and 9 are what you want when you are looking for undervalued stocks for purchase. Low scores may be good for short-sell, but if this is what you want to do, I would also additionally filter for overvaluation as an added insurance.
- 0-3: Financially weak; often value traps or distressed companies.
- 4-6: Mixed signals; further research required.
- 7-9: Strong financial health; more likely to outperform the market.
How to Use the Piotroski F-Score in Your Investment Process
The easiest way to find high Piotroski F-score stocks is to filter for it in your stock screener if your stock screener offers it. I use Stock Rover and it offers a convenient Piotroski F-score filter. Other screeners such as Finviz or GuruFocus may have this filter built in as well.
Once you shortlist stocks with high F-scores, you can then consider other valuation metrics such as P/E or P/B ratios. This intersection of undervaluation and financial strength will give you quality companies selling at attractive prices – a solid foundation to build your high-performing value investing portfolio on.
As you monitor your portfolio, keep an eye on the score changes. A decline in the score may indicate a deterioration in the financial strength and you may want to conduct further due diligence if you see this happening.
Piotroski F-score reduces risk by focusing on financially sound companies. It is simple to implement with accessible financial data. It improves returns when applied to undervalued stocks. At the same time, it does not account for future growth potential and it may not be very effective for large-cap stocks (that have much better access to capital markets for funding)
The Piotroski F-Score is an essential tool in the value investor’s toolkit. By assessing a company’s financial health through nine simple criteria, it helps you avoid traps and identify companies with strong fundamentals. Incorporate this score into your screening process, and you’ll be better equipped to find stocks that are not only undervalued but also positioned to thrive.
Photo by Joshua Mayo on Unsplash
