Will Your Company Go Bankrupt? Enter Altman and Piotroski

• Posted by scheplick
• on April 20th, 2012

Before a company’s stock is bought or sold investors would like to know the probability of that particular company going bankrupt. A low probability of bankruptcy would ensure that the company is in strong financial shape whereas a high probability would suggest that the company is in poor financial shape. The probability of bankruptcy is an important metric because an investor will lose his/her entire investment if they hold a company’s stock when it goes bankrupt. On Wall Street, the probability of a company going bankrupt is included in almost every investment thesis and stock pitch. There are several ways to calculate the probability of a company going bankrupt and the calculation has evolved over the years. The first calculation was Altman’s Z-Score. Next came Piotroski’s Score, then Shumway’s Simple Hazard Model, and most recently John Y. Campbell’s Model for Predicting Financial Distress. In this post I would like to cover the first two bankruptcy calculations: Altman’s Z-Score and Piotroski’s Score. (Note: In a future post, part 2, I will cover Shumway and Campbell.) The key here is to use these metrics to evaluate your portfolio’s risk and also to find potential investment opportunities.

The Altman Z-Score, initiated in 1968 by Edward I. Altman while an assistant professor at NYU, was one of the the first mainstream bankruptcy calculations. Altman’s calculation dominated Wall Street during the 1980s and 1990s because it gave investors a quick glimpse at the probability of a company going bankrupt. Altman’s Z-score is calculated using a company’s balance sheet and income statements but it has also been used to evaluate sovereign risk and credit in the Eurozone. The Altman-Z score is calculated like this (from Wikipedia):

Z = 0.012T₁ + 0.014T₂ + 0.033T₃ + 0.006T₄ + 0.009T₅

T₁ = Working Capital / Total Assets. (Measures liquid assets in relation to the size of the company.)

T₂ = Retained Earnings / Total Assets. (Measures profitability that reflects the company’s age and earning power.)

T₃ = Earnings Before Interest and Taxes / Total Assets. (Measures operating efficiency apart from tax and leveraging factors.)

T₄ = Market Value of Equity / Book Value of Total Liabilities. (It is a possible warning signal when the market value of the firm is substantially below the book value.)T₅ = Sales/ Total Assets. (A measure for total asset turnover and efficient use of firm assets.)

 

Once the Altman Z-score has been calculated, the probability of bankruptcy falls into three sets: A company with a  Z-score greater than 2.99  is considered to be in a “Safe Zone” and has a low likelihood of bankruptcy, a Z-score between 2.99 and 1.81 is considered to be in a “Grey Zone” and could go in either direction, and a Z-score less than 1.81 is in a “Distress Zone” and has a high probability of bankruptcy.

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Although the Altman Z-score has been around the longest, over the last few years many new calculations have risen. An alternative to Altman’s Z-Score is the Joseph Piotroski Score. Piotroski created this metric for value investors and it is praised for its simplicity, ease of use, and accuracy. It is an excellent way for non-quantitative traders and investors to evaluate their company’s financial strength. Here is how it works: Look at the nine bullets I’ve listed below and score one point if your stock passes a bullet point and zero if it doesn’t pass a bullet point. The maximum score is 9 (excellent financials) and the lowest score is 0 (poor financials):

1. Net Income: Score 1 if last year’s net income is positive.
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2. Operating Cash Flow: Score 1 if last year’s cash flow is positive.
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3. Return On Assets: As a measure of profitability, score 1 if last year’s Return on Assets (ROA) exceeds prior-year Return on Assets.
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4. Quality of Earnings: Score 1 if last year’s operating cash flow exceeds net income, as a measure that warns for potential accounting gimmicks.
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5. Long-Term Debt vs. Assets: Score 1 if the ratio of long-term debt to assets is down from the year-ago value.
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6. Current Ratio: Score 1 if Current Ratio has increased from the prior year.
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7. Shares Outstanding: Score 1 if the number of shares outstanding is no greater than the year-ago figure, as a measure of potential dilution.
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8. Gross Margin: Score 1 if full-year Gross Margin exceeds the prior-year Gross Margin to measure the company’s competitive position.
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9. Asset Turnover: Score 1 if the percentage increase in sales exceeds the percentage increase in total assets, as a measure of the company’s productivity.

Both the Altman Z-Score and Piotroski Score are excellent tools to help monitor the risk of your investments. I personally have had the most success using the Piotroski Score, but both are equally valuable. This is part 1, which covers Altman and Piotroski while Part 2 covers Shumway and Campbell.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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