The Piotroski score is a measure developed by Stanford University accounting professor Joseph Piotroski to determine the financial strength of a company. It uses nine criteria to determine if a stock is undervalued and has potential for price increases. The Piotroski score is used to identify high-performing value stocks by analyzing their profitability, leverage, liquidity and operating efficiency.
History of the Piotroski Score
The Piotroski score was first introduced in Joseph Piotroski’s 2000 research paper “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers”. Piotroski developed the score while studying how to improve investment returns using accounting-based fundamental analysis. His goal was to find a simple scoring system that could identify the healthiest companies among a group of struggling value stocks.
Piotroski found that high book-to-market stocks, which are considered value stocks, could be separated into financially strong and weak companies by analyzing nine financial indicators. By only investing in the financially strong value companies, Piotroski was able to achieve higher returns compared to the overall high book-to-market category. The Piotroski score allows investors to systematically incorporate fundamental signals into their value investing strategy.
How the Piotroski Score is Calculated
The Piotroski score is calculated by awarding one point for each of nine criteria met by a company. The nine criteria are divided into three categories – profitability, leverage, and operating efficiency. The final score is the sum of all points received across the nine tests and can range from zero (worst) to nine (best).
Here are the nine criteria used in the Piotroski score:
| Profitability Tests |
|---|
| 1. Net Income: Score 1 point if current net income is positive |
| 2. Operating Cash Flow: Score 1 point if current cash flow from operations is positive |
| 3. Return on Assets: Score 1 point if ROA exceeds prior-year ROA |
| Leverage Tests |
| 4. Quality of Earnings: Score 1 point if current operating cash flow exceeds net income |
| 5. Debt Ratio: Score 1 point if long-term debt to assets has decreased from the prior year |
| Operating Efficiency Tests |
| 6. Margin Improvement: Score 1 point if current gross margin exceeds the prior year’s margin |
| 7. Asset Turnover Improvement: Score 1 point if the current year’s asset turnover ratio exceeds the prior year’s |
| 8. Equity Issuance: Score 1 point if the company did not issue common shares/equity over the prior year |
| 9. Margin Strength: Score 1 point if current gross margin exceeds the prior year’s margin and asset turnover exceeds prior year’s turnover |
After calculating each of the nine criteria, the final Piotroski score is determined. The higher the score, the stronger the financial condition and fundamentals of the company.
Interpreting the Piotroski Score
Piotroski considered stocks with scores of 8 or 9 to be the best value investments, as they demonstrated strong financials across the board. Stocks with scores of 7 and below were considered weaker prospects.
Here is a rough guide to interpreting Piotroski scores:
- 9-7: Strong fundamentals
- 6-4: Average fundamentals
- 3-0: Weak fundamentals
A high score indicates a company has improving profitability, deleveraging balance sheets, and increasing operating efficiency. This demonstrates financial strength and the ability to deliver stronger future performance. Low scores signal potential problems with the company’s financials.
Benefits and Drawbacks of the Piotroski Score
The Piotroski score is beneficial for the following reasons:
- It’s simple – Easy to calculate and interpret.
- Objective – Based on accounting data, not subjective forecasts.
- Proven results – High-scoring stocks have outperformed in backtests.
- Value focus – Helps identify strong companies among struggling value stocks.
- Low cost – Requires only basic accounting data to calculate.
Potential drawbacks include:
- Backward-looking – Relies on historic accounting data.
- Limited scope – Analyzes only basic balance sheet and income metrics.
- Data quality – Accounting data can sometimes be manipulated by companies.
- Static weighting – Each of the 9 criteria is equally weighted.
- Sector biases – Tends to favor certain sectors over others.
While useful, the Piotroski score should not be relied on as a solitary factor for stock selection. It is best used in combination with other metrics and qualitative assessments as part of a comprehensive analysis.
Studies on the Effectiveness of Piotroski Score
Numerous academic studies have analyzed the effectiveness of the Piotroski score in predicting future stock performance. Some key findings include:
- Piotroski’s original 2000 paper showed high-scoring value stocks earned an annual return of 23% compared to just 5% for low-scoring stocks from 1976-1996.
- A 2012 study found strong performance persisted in the U.S. and internationally through 2010. High-minus-low Piotroski portfolios outperformed by 7.5% annually.
- However, a 2016 study saw diminishing returns to the high-minus-low Piotroski strategy in the U.S. from 2000-2014.
- Research shows that combining Piotroski score with other value factors like price-to-book and momentum can improve returns.
Overall, the research demonstrates the Piotroski score has solid predictive power, especially when combined with other metrics. However, its efficacy may be partially degraded over time as the strategy gained popularity.
How Investors Use the Piotroski Score
Here are some of the most common ways investors utilize the Piotroski score:
- Screening tool – Scan for stocks with 8 or 9 scores to generate buy ideas.
- Risk assessment – Avoid stocks with very low scores that suggest financial problems.
- Long/short strategy – Go long stocks with high scores and short stocks with low scores.
- Fundamental analysis – Incorporate alongside ratios like ROA and P/B as part of overall analysis.
- Portfolio construction – Use score to tilt portfolios towards stocks exhibiting quality and value characteristics.
The Piotroski score allows investors to quickly evaluate the financial strength of value stocks. It can be used in a variety of quantitative and fundamental strategies.
Criticisms of the Piotroski Score
Some common criticisms of the Piotroski score system include:
- The accounting-based metrics face limitations. Earnings can be manipulated and the balance sheet is backward-looking.
- The nine factors are simple binary tests and may not fully capture financial performance.
- All nine criteria are equally weighted. Custom weighting may improve results.
- Cutoffs for high vs. low scores are arbitrary. Different breakpoints could be tested.
- It omits important qualitative factors like competitive position, management quality, and valuation.
- Like most value strategies, it performed poorly during the growth-dominated dot com bubble.
While the Piotroski score has demonstrable predictive power, investors should be aware of its limitations like any metric. The score is most useful when blended with other analysis.
Examples of Piotroski Score Analysis
Let’s walk through a basic Piotroski analysis for the following hypothetical Company XYZ:
| Financial Criteria | Year 1 | Year 2 | Score |
|---|---|---|---|
| Net Income | -$2 million | $1 million | 1 |
| Operating Cash Flow | $5 million | $6 million | 1 |
| Return on Assets | 3% | 5% | 1 |
| Quality of Earnings | OCF $5M > NI -$2M | OCF $6M > NI $1M | 1 |
| Change in Leverage | Increase | Decrease | 1 |
| Change in Liquidity | Decrease | Increase | 0 |
| Equity Offering | Yes | No | 1 |
| Margin Change | Decrease | Increase | 1 |
| Asset Turnover Change | Decrease | Increase | 1 |
| Total Piotroski Score | 8 |
In this example, Company XYZ scored an 8 out of 9. This implies it has very strong financials and fundamentals. You would consider this stock a good value investment based on its Piotroski score. The high return on assets, positive earnings change, improved leverage, and lack of equity issuance are all positive financial signs.
If the company had scored below a 5, it would imply poor fundamentals. You’d want to understand why it was underperforming on so many metrics before considering investing.
Conclusion
The Piotroski score is a simple but effective metric for determining the financial strength of value stocks. The high-minus-low Piotroski strategy has demonstrated strong historical returns, especially when combined with other factors. While the system has limitations, it provides useful insight into the quality of a company’s financials.
Investors can incorporate Piotroski scoring as a screening, risk management, or portfolio construction tool. It is best used in conjunction with other types of analysis. Overall, the Piotroski score allows investors to make more informed decisions on which value stocks are most likely to outperform the market.
