Complete Guide to the Piotroski F Score

Value investing is both an art and a science, but for most of us, it can also be simply frustrating. 😤

It is tough to find the right stock to invest in at the right time, especially in an expensive market where everything seems to be pumping. So for investors looking to pick up some cheap but solid stocks, the opportunities can seem really slim. If only there was some way to screen for the absolute best cheap stocks…

According to a brilliant accounting professor and financial reporting expert, there is indeed a back-tested strategy that can help you find the best value stocks with the most significant potential gains. 

His strategy is based on a rating system for value stocks called the Piotroski F Score. It is one of the best strategies to invest in value stocks, and due to its simplicity, even retail investors can use it with ease.

In this article, we’ll go over the Piotroski F Score, the core principles it is based on, and how you can use it to find new opportunities for your portfolio!

What is The Piotroski F Score? 📚

The Piotroski F Score is a financial rating system for stocks based on fundamental analysis, and it calculates a comparative score of a company’s inherent value. It was first described in a paper called Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, published by Joseph D. Piotroski in 2000. 

In his paper, the Stanford accounting professor examines “whether a simple accounting-based fundamental analysis strategy, when applied to a board portfolio of high book-to-market* firms, can shift the distributions of returns earned by an investor.” 

*”High book-to-market firms” refer to firms with a high book-to-market ratio, which is the inverse of the price-to-book (PB) ratio. So, high book-to-market firms are firms with a low PB ratio. 📉

Essentially, the paper seeks to examine if you can get higher gains by using this strategy and find the crème de la crème of value stocks? The conclusion is that you can—the author proved that his system would have beaten the average return on the stock market by 13.4% by backtesting it against the market from 1976 to 1996. 

He defines the final score of the stock as its F Score. There are 9 conditions one should look for in a value stock, and for each condition that’s fulfilled, we will allocate one point to the stock’s total score. The higher the F Score, the more valuable the stock is. 💰

We’ll take a practical approach and take a deeper look at the criteria that compromise the Piotroski F Score in the sections below. However, we feel it is also equally important to understand the broader implications of the paper’s insights and the why behind the methodology.

Piotroski’s Insights: How Stock Markets React to Undervalued Stocks

There are several interesting broader insights that Piotroski’s paper discusses. Still, the most crucial one relates to how the stock market tends to incorporate historical financial information for value stocks that are not yet “widely followed.” 

In the paper, he notes this interesting insight into the market’s trading psychology: “the success of the strategy is based on the ability to predict future firm performance and the market’s inability to recognize these predictable patterns.“

His research found that around 1/6th of the total annual return difference between the “winners” and the “losers” is earned over just 12 trading days. This is because the market is often surprised by the future earnings announcements of these companies and then quickly reacts to the news, which makes stonks go up. 🚀

By investing before the market reacts to our picks, we take advantage of the information lag and get higher returns.

Value stocks are not priced based on their fundamental value and become “surprising winners” as they break through. So, suppose we can identify the correct financial signals in a stock. In that case, we can effectively beat the market (which is insensitive to the signs until the company’s actual future earnings are announced).

Piotroski F Score is a system that we can use to screen value stocks for these financial signals. However, it is not a magical formula. The author notes that alternate systems using the same broad concepts can be created and offer similar benefits. 

Yet, since we all cannot be math and accounting geniuses and come up with our own F_SCOREs, it serves as a great model for the average retail value investor looking for above-average returns from their value portfolio.

What Does the Piotroski Scale Tell You? 🤔

The Piotroski scale gives us a rating for how strong the financial fundamentals are for a value stock.

There are nine conditions used to compute the F Score, each contributing a point to the score, i.e., the range for the score is between 0 and 9. So naturally, companies with the highest scores should theoretically offer the highest potential returns relative to the market. Conversely, companies with the lowest scores would lose the most against the market average.

How to Calculate the Piotroski F Score 🧮

The Piotroski F Score is calculated based on data obtained from a stock’s financial statements. These statements are public, and anyone can get the data that has to be plugged into the system. Fortunately, there is no need for manually collecting all that information since just about all premium stock trading apps can do it automatically for you and have dedicated screeners for the Piotroski F Score. 

So, while it is unlikely you’ll ever need to do a manual analysis for calculating the Piotroski F Score, we demonstrate how the process works and, more importantly, the nine binary parameters it uses. 

What Are Binary Parameters? 👨‍💻

Like most people on social media, binary parameters do not understand nuance at all. Instead, they are conditions that can either be true or false.

An example of a binary parameter would be: “If a business has more than $4 million in net sales, the result will be true. Otherwise, the result will be false.” 

The Piotroski F Score is a combination of several conditions that either return a positive or negative response. We assign positive responses a value of 1 and negative responses a value of 0. In the end, all the values are combined together, which gives us the F_SCORE.

Piotroski F Score Categories 🗃

The nine conditions used in calculating the score are divided into three functional groups: 

1. Profitability ✅
2. Leverage, liquidity, and source of funds ✅
3. Operating efficiency ✅

The individual conditions under the categories are as follows:

Let’s take a more in-depth look at each category.

Profitability Conditions 📊

There are four profitability conditions that we look at: positive net income, positive return on assets in the current year, positive cash flow in the current year, and cash flow from operations being greater than net income. 

These conditions are pretty self-explanatory as they check for familiar financial figures and if they are over a specific limit. So let’s take a look at why these particular conditions are picked:

• ☑️ We can judge the company’s ability to generate funds internally using the metrics for current profitability and cash flow realizations. This essentially proves that the company has the competence to generate funds via its operations.

• ☑️ Along with checking for profitability in the first three conditions, in the last one, we check if the cash flow from operations is greater than the net income. In the case of value stocks specifically, the relationship between earnings and cash flow levels is significant (Sweeney 1994). 

• ☑️ If the company cannot generate cash flows greater than net income, future profitability and returns will likely be disappointing.

Leverage, Liquidity, And Source Of Funds Conditions ⚖

These conditions are checks for the changes in the company’s capital structure and if it can meet its future debt obligations: Lower ratio of long term debt in the current period compared to the previous year, higher current ratio this year compared to the previous year, no new shares were issued in the last year. 

Here’s why we use these conditions specifically:

• ☑️ Value stocks are often financially burdened, and it is essential to look for any signs of change in liquidity, leverage, or use of external financing.

• ☑️ If the ratio of long-term debt increases in the current period, it is a signal that the company (which is usually supposed to be financially distressed) is increasing its financial leverage, typically due to an inability to generate funds from its operations. Additionally, an increase in long-term debt also means terrible things for the growing company’s financials which can impede its growth.

• ☑️ Inversely, an increase in the company’s current ratio signals that the firm can generate enough funds to pay off its existing debt obligations, which is a good sign for a value company. 

• ☑️ For the last condition, we check if the company has issued new equity shares or not. The reason why the issuance of new equity shares is terrible is the same as why an increase in external debt is alarming for a value stock; it reflects that the firm’s current ability to manage its debt is questionable, and hence makes it a relatively worse option when compared to value stocks that do manage its debt efficiently.

Operating Efficiency Conditions 👨‍🏫

The last category has two conditions that check for the efficiency of the company’s operations: A higher gross margin compared to the previous year and a higher turnover ratio compared to last year. The reasons why we check for these conditions are as follows:

• ☑️ These two ratios are fundamental when calculating the return on assets for a company and signal a lot about how efficient the company’s operations are.

• ☑️ A higher gross margin usually means a reduction in the company’s costs or an increase in its earnings, both of which are naturally good signals for a growing company.

• ☑️ Similarly, an increase in the turnover ratio demonstrates an increase in sales or an increase in operating efficiency (as the company generated more income in the current year with the same assets as last year). 

Time for a Practical Example! 📘

Now that we’ve covered all parts of the system let’s see how it all works together and how we can use it to find the best of the best when it comes to value stocks. For this example, let’s assume we’re in the market looking for a stock that’s undervalued by the market but has the potential to perform exceptionally well in the long-term future. 

Value stocks usually have a lower book-to-market ratio than the industry average, so based on that, we have decided to find two exciting but different stocks—General Motors or PVH Corp (both large-cap value stocks).

Since they operate in entirely different industries, it can be hard to make a comparative decision. However, we know that both of them have a price-to-book (PB) ratio that’s much lower than their industry’s average. Additionally, when we factor in the market share of the companies, we realize that both of them offer similar value propositions. 

This is usually a good point to refer to the Piotroski F Score to find out which company’s fundamentals are stronger. When we check the scores for the two using the criteria from Joseph Piotroski’s book, we find the following results:

According to the Piotroski F Score analysis of the two stocks above, it is indicated that General Motors would be a better value stock on a strictly fundamental analysis basis even though it might offer a much lower book-to-market ratio than its industry average.

What is Considered a Good Piotroski Score?

Since there are nine parameters, the Piotroski F Score for a company can be between 0 and 9. So naturally, companies at the bottom of the scale (0-3) can be considered companies with weak fundamentals. On the other hand, companies at the top of the scale (8-9) have powerful fundamentals and are most likely to keep performing well in the future.

How to Invest Using the Piotroski F Score 💵

In an ideal world, we should pick stocks based on their Piotroski F Score again. However, like all financial models and metrics, context is vital. One of the significant pitfalls retail investors should avoid while using the Piotroski F Score is ignoring the general industry trends.

Since the metric is entirely based on financial statements, the scores are not consistent for all industries as the accounting standards and SOPs can vary. Additionally, it can be harder to generate positive profitability metrics for some sectors than others. 

In the previous example in this article, we found General Motors to have a higher score than PVH Corp. However, we did not consider the industry average like we did when considering the book-to-market ratio. 

A quick search reveals the following for the competition.

While Ford scores the same on the scale, its P/B ratio is higher, and in the case of Fiat Chrysler, the P/B ratio is lower, but its F Score is lower as well. 

As for Tesla, it can be hard to make the case that it’s a value stock given its high P/B ratio. Yet, its industry-changing approach towards electric vehicles is an outlier and carries a strong score due to its operational efficiency. However, it is also the most volatile option on the list. So, we can safely conclude that GE represents the best value stock out of the following stocks.

As demonstrated above, Piotroski F Score is a valuable metric and can help in stock valuation when combined with other metrics. Moreover, since it is based on general accounting and financial reporting principles, it allows us to quickly glance at the companies’ financial performance and stability, which is essential for value stocks to keep growing.

How Accurate is the Piotroski Scale? 🎯

From a technical point of view, the Piotroski F Score is 100% accurate. It is essentially taking figures from companies’ financial statements and checking for a few particular things. A more pressing question is the following—how good is it at predicting the future?

It’s important to note that due to unforeseen events like an economic downturn, a recession, or even a once-in-a-lifetime global pandemic, the markets can plummet regardless of what anyone’s fancy models or indicators predict. 

Yet, ignoring any extreme situations, there is likely quite a lot of merit to the Piotroski Scale. Since it is based on solid fundamental accounting principles, a company with a high score indicates that it is financially stable at the very least. Since value stocks tend to be financially distressed, an index that measures their financial efficiency is undoubtedly a helpful metric to have in your toolkit when researching stocks.

Can a Stock Do Well Despite Having a Bad Piotroski Score? 🧐

In general, yes, a stock can do well despite having a bad Piotroski score. 

In fact, when looking at the historical data from the last two decades, we find several stocks with low scores that have made massive gains over time. A particularly prominent example of such a stock would be Tesla. Here’s some historical data that proves it:

It is also possible to argue that the model, which is older than most college first-year students, is a tad bit outdated when it comes to the current stock market. However, several improvements have been suggested to the original model to incorporate changes such as incorporating net-share repurchases and additional free-cash-flow metrics.

Overall, the Piotroski F Score is just another indicator that you can use for stock analysis. It is handy for differentiating between value stocks in the same industry, but over-reliance on it (or any single metric), especially in today’s hyper-charged markets, shouldn’t be practiced. 

Conclusion 💬

Everyone wants to buy low and sell high, but finding the best value stocks combines luck, science, and art. The Piotroski F Score offers a comprehensive approach towards selecting fundamentally strong value stocks, albeit the usefulness of the method is somewhat questionable in today’s market.

Now that you’ve made your way through the article, we hope you’re one step closer to finding the best value stocks for your portfolio. Again, we would suggest using a variety of other metrics such as CANSLIM to get the best overview of the market and make the best decisions for your portfolio.

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