The metric ranks companies based on nine important parameters from their financials
Whether the ongoing bull run in the equity markets would continue or a steep correction is on the cards, is a running battle among market gurus. Their moot point has left long term investors on the edge. Whether the time is ripe for investment or not, no time is a bad time to keep your groundwork ready. Market veterans have formulated many scoring methodologies, that can help DIY investors in picking fundamentally strong bets. Investors can then do further research to fine tune the results of such scoring methodologies, before boiling down on their investment choice.
In this week’s series we discuss one such score—the Piotroski F- score, devised by Joseph Piotroski, that ranks companies based on certain important parameters from their financials.
The Piotroski F score is assigned to companies by evaluating them on nine financial parameters. With one point for every favorable metric, companies are scored between 0-9. Companies that score in the range of 7 to 9 are considered to be financially sound, while the weak ones score 0 to 3. But an important point to remember is that the score involves a great deal of recency bias, since it mostly encompasses improvements in financial metrics over the recent financial year. Hence, it would be wise to consider the F scores of companies over multiple years, to pick consistent outperformers.
Besides, it would be best to run the score on companies that trade at lower valuations (price to book value), given their potential to scale up from hereon. Companies that are financially sound as determined by F-score, but at the same time are trading cheap are the ones that are likely undervalued and may provide opportunities.
The criteria for the score broadly categorize under operating efficiency (2 sub parameters), profitability (4), and source of funds (3).
Under the operating efficiency category, businesses are awarded one point each for improvement in operating margins and asset turnover ratio, over the previous year.
Under the profitability category, one point is awarded each for positive net profits, and positive cash flows from operations. If companies demonstrate any improvement in RoA, when compared to previous year, one more point is awarded. That apart, companies that generate higher operating cashflows, than their net profits are awarded one more point.
The last category on source of funds, weighs companies based on their leverage and liquidity decisions. One point is awarded each for non-dilution in equity and lower long term debt when compared to last year. Besides, the liquidity in the business is measured using the current ratio – one point for higher ratio than the previous year. Current ratio, derived by the formula: current assets divided by current liabilities, helps evaluate a company’s ability to fund its immediate payment obligations, using its own assets.
Using the Capitaline database, we filtered stocks that traded (as of June 2020) below the median price to book value (10 times), from the Nifty 100 index (excluding financials). That is we took the bottom 50 stocks of the index, basis their valuation in June last year. To see how well the Piotroski- F score helps pick good bets, we then scored these companies using their FY20 financials and compared it to their stock performance over the last one year.
The result was a 50-50.. Five among the ones that scored 7-9 in FY20 even managed to beat the market (Nifty 50) returns by a good margin. These were prominent names such as Wipro, Piramal Enterprises, UPL, Adani Transmission, and Adani Enterprises.
However, the on going bull run also pulled up the returns for the ones that scored the lowest in FY20. While Mahindra and Mahindra scored 2, Eicher Motors, Indian Oil Corporation and Bharati Airtel had a Piotroski F score of 3 in FY20. All these stocks, barring Bharti Airtel, rallied more than 35 per cent.
While the Piotroski score does indicate the financial soundness of a company, stock returns are not a given. Hence looking at score alone may not be the right way to zero in on your investment choice. However, this screener can sure be a starting point to undertake further research into the businesses we have highlighted below.
Who made the cut
Despite the pandemic having wreaked havoc for most businesses, as many as 19 companies scored between 7-9, in FY21, from among those that are now trading below a price to book of 10 times. This indicates that several businesses, managed to thrive well last year too.
Cashing on the on-going commodity upcycle, Vedanta managed to score the highest (9), implying an improvement in each of the above mentioned metrics. Five others were top scorers last year, whose score while dropping a notch owing to the pandemic, continued to be among the resilient businesses (score 7-9). A few such as HPCL, Petronet LNG, Tata Consumer Products and Cadila Healthcare, inched up to a score of 8 from the grey zone (score of 4 to 6) last year.