Financial Statement Analysis Blog #10 – earnings quality per Piotroski Score
“Rather fail with honor than succeed by fraud.”
As promised in the last blog post, we will cover the other tool to assess earnings quality in this post: the Piotroski Score.
The Piotroski Score method was developed by Professor Piotroski of the University of Chicago. The method has been proven to predict that strong stocks (with a Piotroski score of above 8 points) as a group outperformed a portfolio of all value stocks by 7.5% annually over a 20-year test period. He also found that weak stocks (with Piotroski score of less than 2 points) were 5 times more likely to go bankrupt or delist from the stock market due to financial problems. The Piotroski score is widely used in stock screening. The method to calculate it goes as follow:
· One point is awarded for each test that a stock passed.
· Net Income: Bottom line. Score 1 if most recent year net income is positive.
· Operating Cash Flow: A better earnings gauge. Score 1 if most recent year cash flow is positive. This test can identify potential accounting issues, as cash flow is usually greater than net income due to depreciation and intangible asset amortization charges.
· Return On Assets: Measures Profitability. Score 1 if most recent year ROA exceeds prior-year ROA.
· Quality of Earnings: Warns of Accounting Tricks. Score 1 if most recent year operating cash flow exceeds net income.
· Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets are increasing, score 1 anyway.)
· Current Ratio: Measures increasing working capital. Score 1 if CR has increased from the prior year. Is the company getting financially stronger?
· Shares Outstanding: A Measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure. Is management buying back shares and being reasonable with options grants?
· Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM. Has the company been able to maintain pricing power against cost of goods?
· Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets. This can identify unprofitable investments by management.
With our example company Caterpillar (CAT), the Piotrosky score is calculated as follow:
As we can see from the Piotroski’s score analysis:
CAT’s debt is increasing
The company is not getting financially stronger
From the 2015 and the 2014 10-Ks, management has been buying back shares
It doesn’t seem that the company has been able to maintain pricing power against COGS
CAT’s Piotroski’s score of 5 is not less than 2 (weak) or more than 8 (strong), indicating a mediocre performance as measured by this score.
The Excel file that calculates the above figures and drives the conclusion is embedded.