The Piotroski score is designed to identify high-quality firms – ie, those that are growing profits without resorting to accounting tricks, increasing balance-sheet risk or sacrificing margins for higher volume.
It’s a fairly simple screen looking at nine separate criteria. If the firm passes each test it earns a one, otherwise it scores a zero; these individual marks are added to give a total Piotroski score between one and nine. Stocks with a score of five or more are considered to be reasonably strong and studies suggest that value stocks with a high score tend to outperform.
The nine criteria are:
1. The company needs to show positive net income – in other words, it has to make money.
2. Same goes for operating cash flow.
3. There’s an extra mark if operating cash flow is greater than net income, ie, the profits are producing hard cash.
4. Profitability should be improving, too. If a company’s return on assets is better than the previous year, it scores a point.
5. A point is also scored for a rising gross profit margin.
6. Then the balance sheet comes under the microscope. The ratio of total debt divided by total assets has to drop.
7. Working capital meanwhile, should be growing. Working capital is defined as the difference between current assets, such as stock and debtors, and current liabilities such as creditors. More working capital generally means a business is growing.
8. A point is scored for signs of rising productivity, where a company’s sales rise compared with its assets.
9. Finally, Piotroski likes to see the number of shares in issue drop, or at least remain the same. Doling out new stock to raise cash could mean a management is being lazy – and it also dilutes existing shareholders’ profits.