piotroski-score

What Is The Piotroski Score? The Piotroski Score In A Nutshell

Business / By /

The Piotroski score was named after Joseph D. Piotroski, an American professor of accounting at Stanford University’s Graduate School of Business. The Piotroski score is a measure of the strength of a firm’s financial position used to identify undervalued companies through nine criteria: profitability (4 sub-criteria), leverage liquidity & source of funds (3 sub-criteria), operating efficiency (2 sub-criteria).

AspectExplanation
Piotroski ScoreThe Piotroski Score, developed by Stanford University accounting professor Joseph Piotroski, is a financial scoring system designed to assess the financial strength and overall health of a company. It is particularly useful for evaluating the financial performance of value stocks and identifying potential investment opportunities.
Components– The Piotroski Score is calculated based on a set of nine financial indicators, each of which receives a score of either 0 or 1. These indicators assess various aspects of a company’s financial condition, including profitability, liquidity, leverage, and operating efficiency.
– A score of 1 indicates a favorable outcome, while a score of 0 indicates an unfavorable outcome. The scores are then summed to determine the overall Piotroski Score, which can range from 0 to 9.
Key Indicators– The nine key financial indicators used in the Piotroski Score include measures such as positive net income, positive operating cash flow, higher return on assets (ROA), lower long-term debt to assets ratio, and higher current ratio. These indicators reflect a company’s ability to generate profits, manage its finances, and operate efficiently.
– A higher Piotroski Score indicates stronger financial health and suggests that the company may be a more attractive investment.
Investment Strategy– Investors often use the Piotroski Score as a screening tool to identify financially strong companies with potential for value investing. Companies with higher scores are considered more likely to outperform those with lower scores.
– However, the Piotroski Score is just one factor to consider in investment decisions, and it should be used in conjunction with other financial analysis methods and due diligence.
Limitations– The Piotroski Score is a static measure based on historical financial data and may not capture dynamic changes in a company’s financial condition.
– It is most applicable to certain types of stocks, such as value stocks, and may be less relevant for growth stocks or companies in rapidly evolving industries.
– Investors should use the Piotroski Score as a starting point for further research and not as the sole basis for investment decisions.
ConclusionThe Piotroski Score is a valuable tool for investors seeking to identify financially strong companies for value investing. It provides a structured approach to evaluating a company’s financial health and can help filter out companies with weaker financial positions. However, it should be used as part of a comprehensive investment analysis and not in isolation. Investors should consider other factors, such as industry trends and qualitative factors, in their decision-making process.

Understanding the Piotroski score

Piotroski devised a way to find the best value stock investments by evaluating the financial position of a company against nine criteria. Value investors love the approach because it helps them make sense of sometimes confusing financial reports.

To that end, the Piotroski score gives reasonable insight into all aspects of a company’s financial performance, analyzing its income statement, balance sheet, and cash flow statement.

Advantages:

  • Quantitative Assessment: The Piotroski Score provides investors with a quantitative framework for assessing the financial health and fundamental strength of a company. By analyzing specific financial metrics and assigning scores based on predetermined criteria, investors can make more informed investment decisions.
  • Simple and Transparent: The scoring system of the Piotroski Score is relatively straightforward and transparent, making it accessible to a wide range of investors. The criteria used in the calculation are well-defined, allowing investors to understand how each component contributes to the overall score.
  • Identifying Quality Stocks: The Piotroski Score is designed to identify financially robust companies with strong fundamentals and potential for long-term outperformance. High-scoring companies are typically characterized by improving profitability, efficient operations, and solid balance sheets, making them attractive investment candidates.
  • Contrarian Indicator: Low Piotroski Scores may signal potential value opportunities for contrarian investors. Companies with low scores may be overlooked or undervalued by the market, presenting opportunities for investors to capitalize on mispricing and potential turnaround prospects.
  • Long-Term Performance: Empirical studies have shown that stocks with high Piotroski Scores tend to outperform the market over the long term. By focusing on companies with strong fundamentals and financial health, investors can build a portfolio that is positioned for sustainable growth and value creation.

Disadvantages:

  • Limited Scope: The Piotroski Score focuses primarily on quantitative financial metrics and may overlook qualitative factors that could impact a company’s performance. Factors such as industry dynamics, competitive positioning, and management quality are not explicitly considered in the scoring methodology.
  • Historical Bias: The Piotroski Score relies on historical financial data, which may not fully capture current or future market conditions. Changes in economic trends, industry dynamics, or company-specific factors may not be reflected in the score, potentially leading to outdated or inaccurate assessments.
  • Subjectivity in Scoring: While the criteria used in the Piotroski Score are predefined, there is some subjectivity involved in interpreting and weighting each component. Different investors may assign varying degrees of importance to certain metrics, leading to inconsistencies in scoring and interpretation.
  • Lack of Forward-Looking Analysis: The Piotroski Score is based on historical financial data and does not incorporate forward-looking analysis or projections. As a result, it may not capture potential changes in a company’s financial health or performance outlook, limiting its predictive power in dynamic market environments.
  • Not Applicable to All Stocks: The Piotroski Score may be less relevant or applicable to certain types of stocks, such as early-stage companies, cyclical industries, or companies with unique business models. In such cases, the scoring methodology may not accurately reflect the underlying fundamentals or growth prospects of these companies.

Evaluating the nine criteria of the Piotroski score

The Piotroski evaluates nine criteria spread across three groups. One point is awarded for every criterium that is satisfied. If the company does not satisfy a criterium, no points are added or subtracted.

Profitability

  1. Positive net income. 
  2. Positive return on assets greater than the previous year.
  3. Positive operating cash flow in the current year. 
  4. Cash flow greater than net income.

Leverage, liquidity, and source of funds

  1. Less long-term debt in the current period when compared to the previous year (decreased leverage). 
  2. Higher current ratio when compared with the previous year.
  3. No new equity issued in the past year. 

Operating efficiency

  1. Higher gross margin than the previous year. 
  2. Higher asset turnover than the previous year. 

Interpreting the Piotroski score

The points from the nine criteria above are then summed to give a total score known as the Piotroski F-Score. 

Companies with a score of 8 or 9 have been found as a group to outperform weak stocks by 7.5% per year over a twenty-year period. Piotroski discovered that weak stocks, with a score of 2 or lower, were five times more likely to experience financial problems.

Companies scoring between 3 and 7 are considered average performance. Some of these companies may also be unsustainable over the long term, while others may be good companies but with little prospect for growth.

It should also be noted that the Piotroski score will not work for every industry, particularly those CapEx-dependent industries where a high level of debt is required to maintain business operations.

Key takeaways:

  • The Piotroski score is a measure of the strength of a firm’s financial position used to identify value stocks.
  • The Piotroski score evaluates nine criteria. One point is awarded for every criterium that is satisfied, while zero points are added for every criterium that is not satisfied.
  • Companies with a Piotroski Score of 8 or 9 are considered good value investments, with weak or unsustainable companies scoring between 0 and 2. The method itself may be inaccurate in CapEx-heavy industries that require debt to fund operations.

Case Studies

Company A: High Piotroski Score (8/9)

  • Profitability:
    • Positive net income: Yes
    • Positive return on assets greater than the previous year: Yes
    • Positive operating cash flow in the current year: Yes
    • Cash flow greater than net income: Yes
  • Leverage, Liquidity, and Source of Funds:
    • Reduced long-term debt compared to the previous year (decreased leverage): Yes
    • Higher current ratio compared to the previous year: Yes
    • No new equity issued in the past year: Yes
  • Operating Efficiency:
    • Higher gross margin than the previous year: Yes
    • Higher asset turnover than the previous year: Yes
  • Piotroski Score: 8

Company B: Average Piotroski Score (5/9)

  • Profitability:
    • Positive net income: Yes
    • Positive return on assets greater than the previous year: No
    • Positive operating cash flow in the current year: Yes
    • Cash flow greater than net income: Yes
  • Leverage, Liquidity, and Source of Funds:
    • Reduced long-term debt compared to the previous year (decreased leverage): No
    • Higher current ratio compared to the previous year: Yes
    • No new equity issued in the past year: Yes
  • Operating Efficiency:
    • Higher gross margin than the previous year: No
    • Higher asset turnover than the previous year: Yes
  • Piotroski Score: 5

Company C: Low Piotroski Score (2/9)

  • Profitability:
    • Positive net income: Yes
    • Positive return on assets greater than the previous year: No
    • Positive operating cash flow in the current year: Yes
    • Cash flow greater than net income: No
  • Leverage, Liquidity, and Source of Funds:
    • Reduced long-term debt compared to the previous year (decreased leverage): No
    • Higher current ratio compared to the previous year: No
    • No new equity issued in the past year: Yes
  • Operating Efficiency:
    • Higher gross margin than the previous year: No
    • Higher asset turnover than the previous year: No
  • Piotroski Score: 2

Key Highlights of the Piotroski Score:

  • Origin and Purpose: The Piotroski score is named after Joseph D. Piotroski, an accounting professor at Stanford University, and it is designed to evaluate a company’s financial strength and identify undervalued stocks.
  • Criteria Categories: The Piotroski score assesses a company based on nine criteria, which are divided into three categories:
    • Profitability (4 sub-criteria)
    • Leverage, liquidity, and source of funds (3 sub-criteria)
    • Operating efficiency (2 sub-criteria)
  • Profitability Criteria:
    • Positive net income.
    • Positive return on assets greater than the previous year.
    • Positive operating cash flow in the current year.
    • Cash flow greater than net income.
  • Leverage, Liquidity, and Source of Funds Criteria:
    • Reduced long-term debt compared to the previous year (decreased leverage).
    • Higher current ratio compared to the previous year.
    • No new equity issued in the past year.
  • Operating Efficiency Criteria:
    • Higher gross margin than the previous year.
    • Higher asset turnover than the previous year.
  • Interpreting the Piotroski Score:
    • The Piotroski F-Score is calculated by summing the points awarded for each satisfied criterion.
    • Companies with a score of 8 or 9 tend to outperform weak stocks by 7.5% per year over a twenty-year period.
    • Companies with scores of 0 to 2 are considered weak or unsustainable, while those scoring between 3 and 7 are viewed as having average performance.
    • The Piotroski score may not be suitable for industries heavily reliant on capital expenditures and debt to sustain operations.
  • Key Takeaways:
    • The Piotroski score helps identify value stocks by assessing financial health.
    • Each satisfied criterion earns one point, and zero points are given for unsatisfied criteria.
    • Companies with scores of 8 or 9 are typically seen as good value investments, while those scoring 0 to 2 are considered weak.
    • The method may not be accurate for industries where high levels of debt are necessary for ongoing operations.

Main Free Guides:

Connected Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Read next:

Main Free Guides:

More Resources

Discover more from FourWeekMBA

Subscribe now to keep reading and get access to the full archive.

Continue reading

Scroll to Top
FourWeekMBA