I received an email recently asking me to talk a bit more about the Piotroski F-Score. As you know, once a month, I combine the F-Score, the Altman Z-Score, and a valuation rank to find a strong list of companies. I say strong because they have rock-solid balance sheets. They have very little debt. They are getting stronger in this recovery.
Let’s look at what a company needs to get a Perfect Nine on the Piotroski scale. Here are the numbers:
1. A firm gets a point when its return on assets tops 0. We determine ROA by dividing net income by total assets. Therefore, only profitable companies during a specific quarter can earn this point.
2. Another point if the firm’s return on assets is higher than the ROA in the year prior. Why does this matter? Because that increase signals that a firm’s profits are going in the right direction.
3. A firm gets another point if operating cash flow is higher than 0. Operating cash flow is significant. This tells us exactly how much cash a company is producing right now.
4. Another point comes if a firm’s operating cash flow tops its after-tax net income. I pay very close attention to this metric. If a firm doesn’t earn this specific point, there is a strong possibility that they are manipulating their balance sheet to make earnings appear stronger than they appear.
5. Companies can get another point when we measure a ratio of the long-term debt to their total assets. Why does this matter? We want to see a firm cutting its long-term debt as a percentage of assets. Companies get a point because every dollar that repays the debt will improve a company’s equity value.
6. Companies get another point if their current ratio is higher than it was a year ago. The “current assets (cash plus things that can be quickly converted to cash) are divided by current liabilities (bills that need to be paid pretty soon). Pay close attention here.
7. Another point is received if the firm’s total number of shares outstanding is lower than that figure last year. This matters. It signals that the firm might be buying back its stock. When firms buy back their stock, each remaining share outstanding is worth more than it was in the previous year.
8. Another point comes if a firm’s gross profit margin surpasses its gross margin from the same quarter in the previous year. This is important because the measurement tells us if the firm is doing an excellent job at maintaining costs and its margins.
9. Finally, we want to look at the total sales divided by total assets yields. We want that figure to be higher than it was during the same period one year ago. If it does so, it will earn a point.
A total of nine points is a good indicator of a perfect balance sheet. I’ll talk more about the Z-Score later. Once you understand how that figure works, I will discuss the importance of valuation ranks. And once you know all three metrics, I’ll unveil the companies that reached Top Level status heading into June.