Joseph Piotroski is an American professor who specializes in accounting. He wrote an influential paper entitled Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. In the paper, Piotroski laid out a way to improve on a low Price to Book strategy by buying firms with strong fundamentals.
According to Piotroski, these fundamentals can be determined simply by using accounting information released by the company. He tested and found nine accounting indicators which will help improve the returns from a simple low price to book strategy. These indicators fall under the categories:
- Financial Condition
- Operating Efficiency
- Positive Return on Asset (ROA)
- Improvement in ROA
- Positive Cash flow from operations (CFO)
- Cash flow from operations (CFO) > Net Income before extra-ordinary items. CFO < Net Profit is a bad signal about future profitability of the company. Some firms try to artificially boost earnings through accruals. (e.g. push products to channels without getting payment first)
- Reduction in the ratio of long-term debt to average total assets (firms that increase their leverage may be signalling their inability to generate sufficient internal funds to service future obligations)
- Improvement in current ratio
- No raising of external capital (firms that raise capital may be signalling their inability to generate sufficient internal funds to service future obligations)
- Improvement in Gross Profit Margin
- Improvement in asset turnover ratio (total sales divided by beginning total assets)
For each of the nine indicators that the firm passes, it is given a score of one. Therefore, the lowest score you can get is zero and the highest score nine.
Firms that have higher aggregate scores clearly do better than those that have lower scores.