Understanding the Piotroski Score While Investing in Stocks

When it comes to stock market investing, people are not just betting on the stock price to go up. They are, in fact, betting on the underlying company that the stock represents. So, while observing the stock prices and charting patterns does give us some insights, it does not give us the complete picture. Price moves are often reflections of the company’s financials. 

After all, ownership of stock basically represents a share of the company’s present and future profits. While technical analysis and indicators are important tools, any trader or investor should also have an in-depth understanding of the company’s financials.

The rawest way of understanding a company’s financials is going through its quarterly and annual financial statements. These statements include income statements, cash flow statements, and balance sheets. 

Legendary investors like Warren Buffet have spent hours and hours reading companies’ financial statements before investing in them. But not all of us can be like Warren Buffet, with the ability to process such a large amount of data. Moreover, not all of us are full-time investors either, and we work with some time constraints.

How to interpret financial statements?

There has to be a compromise between reading the financial statements and not spending too much on them. The best combination would be to extract a summary of these numbers such that it represents some meaningful data. Several data points represent the relative value of a company and its future growth prospects. 

For example, the price-to-earnings ratio known as PE ratio represents how expensive the stock is as compared to its profits. So, a stock with a PE ratio of 15 is priced at 15 times its current earnings. A similar stock with a PE ratio of five would be more attractive for an investor since its price is relatively lower than earnings.

However, ratios such as the above represent only one side of the story. For example, with the above ratio, we have no information about the company’s debts or profit margins. Is there a one-stop solution that combines the essence of multiple parameters into one single number?

Piotroski score – a one-stop solution for evaluating a stock

A professor working at the Chicago Booth business school in the early 2000s came across the same problem. He decided to combine all the elements that define a company’s profitability, leverage, and efficiency. Not only did he come up with this score, but he also extensively back-tested it. His results showed that stocks with high Piotroski scores significantly outperform the broad markets over multiple decades.

In fact, the components of the Piotroski score can be divided into these three parts. There are in total nine parameters that comprise the score, and each parameter carries one point. For every parameter that the company satisfies, it is awarded one point. Let’s break down the Piotroski score and understand its parts.

Profitability – the bottom line

As discussed above, the objective of any company is to maximize its profits, and hence this part has the maximum weightage – 4 points. This part is further split into four components, each having 1 point.

1. Positive Return on Assets – Return on assets is calculated by dividing the net income by total assets. This point basically evaluates whether the company has generated profits or not. While this may sound simplistic, you will be surprised to know that profitable companies are not as abundant as you would expect. 

2. Positive Operating Cash Flow – It is the cash flow generated by a company by running its primary operations. For example, a biscuit manufacturing company would get cash for selling its final products and spend cash on buying raw materials and paying employees and utilities. If the net of these cash flows is positive, it means it is getting cash from the daily operations.

3. Positive change in Return on Assets – This means that the net income ratio to total assets has increased year over year. This shows that the company can generate more profits for each dollar of the asset it owns.

4. Positive Accrual – Accrual is effectively the difference between operating cash flow and net profits. If operating cash flow exceeds the net income, it indicates a superior quality of earnings.

Leverage, liquidity, and source of funds

This section essentially evaluates if the company’s financing is sustainable. A company too dependent on debt or not having enough cash is likely to falter sooner or later. There are three components here with 1 point each.

1. Decrease in leverage – Leverage is the ratio of long-term debt to long-term assets. If this ratio has decreased, it means the company is reducing debt.

2. Increase in Current Ratio – Current ratio is the ratio of current assets to current liabilities. Current assets are generally liquid, so a higher current ratio means the company won’t have any liquidity problems in the short run.

3. No increase in the number of shares – Companies often issue equity in order to raise more money. While this is good for the company in the long run, it dilutes the existing shareholders, reducing the value of their shares.

Operating efficiency

Finally, we come to evaluate how well the company is utilizing its assets and funds. This part has two components with 1 point each.

1. Increase in Gross Margin – Gross margin is the ratio of revenue minus the cost of goods to the revenue. It tells how efficient the company was at a gross level.

2. Increase in Asset Turnover – It is the ratio of total sales to the average assets in a financial year. It tells us how much sales the company was able to generate from its assets.

Piotroski score is the sum of all the above points. The maximum score is 9, and the minimum is 0. As you can sense from the above Piotroski score does a great job of combining different aspects of a company into one single number.