High Piotroski Scores in Magic Formula Investing
He noticed when reviewing stocks with very low price-to-book ratios that many of them were in poor financial shape, unlikely to survive and deserving of their low valuation.
Piotroski set out to devise a system to take these low price-to-book stock lists and mechanically filter out the ones that were unlikely to survive and prosper, leaving a number of potentially attractive investment opportunities.
Piotroski's method is very simple. A stock is scored by nine different criteria that measure the company's performance between the past two years. The stock gets a "1" for each test it passes, and a "0" for each test it does not. At the end, all of the scores are added up to come up with the Piotroski score.
In this scale, a "9" is a perfect score, passing all tests while "8" is also an excellent score worthy of consideration. Back-testing has found that choosing stocks with low valuations and Piotroski scores of 8 or 9 vastly outperforms the market.
The nine tests are:
1. Net Income: '1' if last year's net income is positive, '0' if not.
2. Operating Cash Flow: '1' if last year's operating cash flow number is positive, '0' if not.
3. Return on Assets Increasing: '1' if last year's return on assets are greater than prior year, '0' if not.
4. Quality of Earnings: '1' if operating cash flow is greater than net income, '0' otherwise. This test can identify potential accounting issues, as cash flow is usually greater than net income due to depreciation and intangible asset amortization (i.e. "non-cash") charges.
5. Long-term Debt vs. Assets: '1' if long-term debt to assets ratio is lower than year-ago number, or if long-term debt is 0. Is the company reducing it's debt relative to assets?
6. Current Ratio: '1' if short-term assets / short-term liabilities ratio is greater than previous year. Is the company getting financially stronger?
7. Shares Outstanding: '1' if outstanding shares is lower or the same as prior year, '0' otherwise. Is management buying back shares and being reasonable with options grants?
8. Gross Margin: '1' if gross margin from last year exceeds previous year, '0' otherwise. Has the company been able to maintain pricing power against cost of goods?