Piotroski’s F-Score: The science of value investing

Nehal Joshipura

The cornerstone of investment philosophy of Benjamin Graham, the guru of value investing, was to invest with “margin of safety”, which means investing in stocks at a deep discount to their intrinsic value and thereby minimizing the downside risk and maximising the upside potential.

In layman terms, he was always interested in buying “One dollar at fifty cents”. Can one buy one dollar at fifty cents? The answer is, YES! A few super-investors of Graham and Dodds Ville, most of them were disciples of Benjamin Graham, have been doing it for years now. The most well-known among all is Warren Buffet. Having said that, they are few and far between.

Value investing for a long time remained in the realm of art rather than science. Separating true value stocks from the falling knives has remained a huge challenge over the years. Several approaches, both quantitative as well as qualitative, used to discern potential winners from seemingly cheap looking stocks have had limited success.

And separating man from the boys had remained a challenge for most professional investors over the years till the time Piotroski introduced his famous F-score in his year-2000 paper titled “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers”. He demonstrated that the Piotroski’s F-score method would have seen a 23 percent annual return between 1976 and 1996, if the expected winners were bought and expected losers shorted.

Let’s have a look at how we can use Piotroski’s F-score to separate true value stocks from long list of cheap stocks in three simple steps.

Step 1: Identify cheap stocks from the universe:

We choose our investment universe (say BSE 500 stocks) and sort stocks in the ascending order of their Price-to-book value multiple (you can try alternative measures like P/E, EV/EBITDA or EV/EBIT as well) and then them into five quintiles (20%), cheapest to expensive stocks.

Step 2: Calculating F-score for the shortlisted cheap stocks

F-score is calculated by using nine criteria divided into three groups: Profitability signals, Leverage, Liquidity and Source of funds and Operating efficiencies. Stock gets 1 or 0 point for each criterion. Total of all points gives Piotroski F-Score between 0 to 9. Following table shows how F-score is calculated.

Profitability Signals

1. Return on Assets: 1 point if it is positive in the current year, 0 otherwise.
2. Operating Cash Flow: 1 point if it is positive in the current year, 0 otherwise.
3. Change in Return of Assets (ROA): 1 point if ROA is higher in the current year compared to the previous one, 0 otherwise.
4 Accruals (Quality of earnings): 1 point if Operating Cash Flow/Total Assets is higher than ROA in the current year, 0 otherwise.

Leverage, Liquidity and Source of Funds

5. Change in leverage (long-term): 1 point if the ratio is lower compared to previous year, 0 otherwise.
6. Change in Liquidity (current ratio): 1 point if the ratio is higher compared to previous year, 0 otherwise.
7. Equity issuance 1 point if there is no new issue of shares that leads to dilution in current year, 0 otherwise.

Operating Efficiency

8. Gross Margin 1 point if the gross margin is positive for current year, 0 otherwise.
9. Change in Asset Turnover 1 point if the ratio is higher compared to previous year, 0 otherwise.

Step 3: Using Piotroski’s F-score in separating value stocks from falling knives:

This step uses F-score calculated in step 2 to separate value stocks from the list of cheap stocks. The stocks with F-score of 7-9 naturally are potential winners and are showing clear sign of improvement in financial performance, whereas stocks with scores of 1-3 are clearly potential losers. The most difficult job is done. We have been able to separate real value stocks from the falling knives from the large list of cheap stocks - Mission accomplished!

The author is Co-founder of InvestmentWaves.