When it comes to building the F-score, we followed Piotroski (2000), which comprises nine fundamentals signals to distinguish winners from losers in a universe of stock. (Please refer
43 An operating system.
44 Four-digit numerical codes that identify a company’s primary business. A company’s primary business is the industry from which the company derives its greatest revenue.
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to the literature review regarding the choice of the different variables by Piotroski.) The model consists of a set of binary financial tests based on the profitability, leverage, liquidity and operating efficiency. The more tests a stock passes the better the investment is said to be. So a stock that passes all the tests out of an F-score of nine would be an excellent stock whilst a stock with a score of zero or one should be avoided. For every test the company passes it receives a one; in the case it fails in the test the company is assigned a zero. The maximum score a firm can be assigned is nine, meaning that the company has improved on all the metrics since it last reported. When we extract company variables we look for the last fiscal year-end period updates. Any stocks that score seven or above can be bought in the portfolio; the following year the test is re-run and the company that is no longer performing regarding the new variables just drops out of the portfolio. Later we test for the data migration and the stability of the F-score in order to understand the likelihood of the models and the volatility in the scores. Therefore, a company will stay in the portfolio as long as it keeps the momentum on beating its previous result in the range of seven to nine.
2.3.2.1 Profitability
Firstly, regarding the profitability the model uses four profitability measures: i) ROA, ii) CFO and iii) Δ ROA. ROA is calculated as net income before extraordinary items divided by total assets, whilst CFO is cash flow from operations divided by total assets. If ROA is positive, the firm is said to be profitable and the firm scores one, otherwise it gets zero. The same notion applies to CFO. Improving profitability is done by simply looking at the year-on-year change in ROA where we let year be fiscal year applied to all our variables. If the current year ROA is greater than the previous year, the firm is awarded a score of one, zero otherwise. iv) If the change in CFO is greater than the change in ROA then the firm scores one, otherwise it gets zero. See for instance Sloan (1996), who shows that earning driven by positive accruals is a bad signal about future profitability and returns.
Four profitability measures are considered: i) ROA, ii) CFO, iii) ∆ROA and iv) CFO > ROA
2.3.2.2 Leverage, liquidity and the source of funds
Piotroski identified three factors that would help avoid stocks running into financial difficulty and each of them is used today in an investor’s assessment. For instance, the three variables are leverage, liquidity and the source of funds, the v) Δ Leverage is the annual change in a company’s leverage as measured by the year-on-year change in the ratio of long-term debt to total assets, vi) Δ Liquid concerns the short-term financing of the business and is measured as the annual change in the current ratio (the ratio of current assets to current liabilities). A rise in the
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current ratio potentially indicates the ability of the firm to service its debt costs, whilst a decline could potentially indicate some short problem financing. vii) Δ Finance is measured as the year- on-year change in shares outstanding; the company scores one if the number of shares outstanding is no greater than a year ago, zero otherwise.
Three balance sheet measures are considered: v) Leverage, vi) Liquidity and vii) Finance
2.3.2.3 Operating efficiency
The model includes two measures of the firm’s operating efficiency, i.e., an increase in operating margin denoted as viii) Δ Margin is measured as the year-on-year change in the gross operating margin; the firm scores one if the full year margin is greater than the previous one, otherwise zero. And the annual change in asset turnover denoted as ix) Δ Turnover is measured as the year-on-year change in turnover; the firm scores one if the percentage increase in sales exceeds the percentage increase in total assets, zero otherwise. This shows how much sales have increased relative to the size of the asset base. An increase of the sales at a greater speed to the change in asset base implies that a firm is generating more business from existing assets rather than simply making acquisitions.
Two operating efficiency measures are considered: viii) Margin and ix) Turnover
Thus, the composite F-score is the sum of the nine variables described as:
F-score = F_ROA + F_CFO + F_ΔROA + F_ACCRUAL + F_LIQUID + F_ΔLEVER+ F_ΔFINANCE + F_ΔMARGIN + F_ΔTURN.