PIOTROSKI F-SCORE ANALYSIS

Premise of Piotroski F-Score:

This type of analysis is generally directed toward smaller, more financially distressed firms. The
analysis is essentially asking the question, “Is the firm currently profitable and realizing positive
cash flow?” High price-to-market firms (value firms) generally exhibit poor historical earnings
performance. This paper summarizes key characteristics
The creator of the analysis, academic Joseph Piotroski, identified certain traits conducive to
improving conditions of a value firm. Piotroski essentially identified factors that may suggest
when a beaten down firm might be improving financially and represent a suitable value firm
investment. It is important to remember that Piotroski is only saying that companies that fit
this category exhibit characteristics suggesting the potential for turnaround. Equally important
is to remember is that a value firm possessing the characteristics does not guarantee
investment success.
Piotroski analysis starts with a key point. On the most basic level, a firm must be currently
generating positive cash flow (or profits in the form of net cash flow). A firm is only interesting
to investigate for potential investment if this condition exists. A key factor in the ability to
generate this positive cash flow is that the positive flow must come from operating activities.
This implies that extraordinary activities like sale of plant and equipment, segments of
operations and similar activities are not included in the analysis of positive cash flow. The
company income statement and other parts of the annual report helps identify extraordinary
items. The firm must also demonstrate the ability to generate positive future cash flows.
Four Categories of Variables: The following variables help measure or identify the
performance-related requirement for positive cash flow.
1. ROA (net income before extraordinary items) – ROA is net income before extraordinary
items divided by beginning-of-the-year total assets. It’s a measure of how efficient the
company is at generating earnings on the use of its assets. This measure of efficiency is
important to finding the ∆ROA noted below. If net income is positive, then ROA is scored with a
“1”. The scaling to assets is also used to calculate ACCRUAL.
2. CFO (cash flow from operations) - the CFO is over beginning-of-the-year total assets. The
scaling appears to be important to finding the ∆ROA noted below. If cash flow is positive, then
CFO is scored with a “1”. The scaling to assets is used to calculate ACCRUAL.
3. ∆ROA – this is defined as the current year’s ROA minus the prior year’s ROA. If current year
exceeds prior year, a score of “1” is assigned.
4. ACCRUAL – the purpose of this measure is to study the relationship between the firm’s
earnings reported and the associated levels of cash flow. Accounting is deemed the “language
of business,” but unfortunately there are instances where accounting theory fails to clearly
present the facts of business transactions. Accrual of expenses and revenue is one such area
where the reality and theory cross paths. Accounting rules want to match the revenue earned
during a specific time period to the exact amount of expenses used to generate the said
income, but company management can play accounting games. Piotroski recognized this short
coming and essentially advised us to be vigilant. Reported profits greater than cash flow from
operations is a potential bad signal about future profitability and returns. This relationship may
be particularly important to value firms, because there are variety of reasons to accrue future
earnings to current periods. (For example, a construction company may be contracted to build
a twenty-four story office building project over three years. The bulk of the revenue to be
earned on the project is not due until the project is completed in three years. The company will
expend large sums of cash and incur many expenses during the three years. If the company did
not report some of the final revenue payment throughout various stages of the project in the
first and second year, then it would be very difficult for investors to compare profits on a year
to year basis. Reported income would be so erratic from year-to-year. Accounting rules
attempt to smooth the profits and revenue over the three year period. Unfortunately,
management can also play games with the estimates used to smooth the profits and revenues.)
Apply the concept of accrual to a Piotroski F-score analysis simply means to subtract ROA from
CFO and determine whether CFO exceeds ROA. A positive CFO result receives a “1”.
The four factors above are measure of profitability. Now, we introduce three new factors. The
new factors measure financial performance and how the firm’s capital structure is changing.
They also are used to indicate the firm’s ability to pay future debt service obligations. This is
important, because many low price-to-book firms are strapped for cash and struggling to
survive. We can make the assumption that these firms are increasing leverage. The leverage is
necessary to keep them from going out of business and the leverage is needed to fight
deteriorating liquidity. A warning sign of financial risk is the nature and use of external
financing.
1. ∆LEVER – measures changes in the firm’s long-term debt levels. It looks at the historical
change in the ratio of total long-term debt to average total assets. A decrease in financial
leverage is a positive signal. A financially distressed firm is assumed to be seeking external
capital to overcome the inability to generate sufficient internal funds. Also, more long-term
debt is likely to further constrain the firm’s ability to be flexible. To receive the proverbial “1”
in this category we need to determine whether the firm’s leverage ratio fell in the year prior to
adding the stock to your portfolio.
2. ∆LIQUID – this factor examines the change from the current ratio (now) and the prior fiscal-
year-end. It is assumed that an improvement in liquidity (∆LIQUID > 0) is a good signal.
Piotroski deemed improved liquidity to be an indication of firm’s ability to service current debt.
If true, the add “1” to the score.
3. EQ_OFFER – This is easy, ask whether the company issued common equity in the year prior
to portfolio formation. Assigned a “1”, if the firm did not issue equity. Distressed firms often
raise external capital and signal an inability to generate sufficient internal funds to service debt
obligations. Distressed companies often issue stock when stock prices are depressed and the
companies are under financial distress. Essentially, issuing stock at a low stock price is not a
prudent time to seek capital. A healthy company would wait until stock prices rebounded if the
reason was simply general market conditions. A company in trouble needs to raise cash and is
willing to ignore prudent business management practices.

The preceding three factors measured liquidity. The following two factors measure financial
performance in terms of operating efficiency. They look for underlying decomposition of the
return on assets.
∆MARGIN – the firm’s current gross margin ratio less the prior year’s ratio. The respective
gross margins are scaled to the respective periods of sales. The assumption is that an
improvement in margins signifies potential improvement in cost factors, a reduction of
inventory costs, or a rise in the price of the firm’s product. If current year gross margin ratio
exceeds prior, then assign “1”.
∆TURN – the firm’s current year asset turnover ratio is defined as the current year total sales
scaled to the beginning-of-the-year total assets. The f-score calculation is the current year less
the prior year’s asset turnover ratio. An improvement in the turnover ratio signals greater
productivity generated from the asset base. The improvement can arise from more efficient
operations (fewer assets generating the same level of sales) or higher sales generated on
existing assets. This might also signal improved or declining market conditions for the firm’s
products. If ∆TURN is positive, assign “1”.

RESEARCH COMMENTS:
The goal of the Piotroski F—score to find companies the exhibit high scores. Many investors
are only interested in companies with perfect scores of nine.
Piotroski F-score is presumed to be more effective when the markets are in a downturn cycle.
At market tops, there are very few worthy high book to market firms available to purchase. At
market tops, you would truly want to be vigilant before you invest in a distressed firm. The
most basic of questions to ask would be why is this firm distressed in such a positive
environment?