How to use a Stanford professor's magic formula to measure business strength and improve returns
What is Ginebra San Miguel's magic formula score? Is it fundamentally strong? Is it under or overvalued compared to its peers?
A little-known Stanford business school professor, who shuns publicity, developed a simple and effective magic formula that measures a business’ fundamental strength, and improves investment returns.
The magic formula is named after the professor and is called the Piotroski Score.
Who is Professor Piotroski?
Joseph Piotroski is a Professor of Accounting at Stanford University’s Graduate School of Business, and a Senior Fellow at the Asian Bureau of Finance and Economic Research (ABFER). Before that, he was an Associate Professor of Accounting at the University of Chicago Graduate School of Business.
Piotroski’s research has been published in scholarly journals in the areas of accounting, finance, and economics; these include The Journal of Finance, Journal of Financial Economics, Review of Financial Studies, Journal of Accounting Research, Journal of Accounting and Economics, The Accounting Review, Management Science, Review of Accounting Studies, and Journal of Law and Economics. His research on value investing has been widely cited in the popular press, used in practice, and highlighted in numerous investment-related websites. He currently serves on the Editorial Advisory Boards of the Review of Accounting Studies, and Journal of Business, Finance and Accounting.
Piotroski earned his PhD from the University of Michigan in 1999, an MBA from Indiana University in 1994, a BS in Accounting from the University of Illinois in 1989, and worked as a tax consultant for Coopers and Lybrand in Chicago from 1989 to 1992.
What is the Piotroski Score?
The Piotroski Score is a 9-point fundamental strength indicator that measures three areas of a business’ financial condition: profitability, financial leverage and liquidity, and operating efficiency.
A business with a Piotroski Score of 8 or 9 is fundamentally strong while a business with a score lower than 3 is fundamentally weak.
In his 2002 research paper, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, Piotroski shows how the magic formula can improve returns when applied to a simple value investment strategy, such as buying businesses with low price-to-book (PB) ratios.
The PB ratio compares a business’ market value (share price x number of shares outstanding) to its book value (total assets - total liabilities). A low PB ratio indicates that a business may be undervalued or cheap.
Piotroski stated that buying undervalued businesses is a great strategy but undervalued businesses are sometimes cheap for a reason — they are fundamentally weak. Less than 44% of businesses with low PB ratios gain a positive return over the following two years. However, using the magic formula to choose fundamentally strong businesses among those with low PB ratios increased the future average return by 7.5% annually.
“The higher a company ranks on Piotroski’s financial strength scale, the better its stock performs over both one- and two-year periods,” Smart Money reported.
Piotroski backtested an investment strategy that bought businesses with the best scores and sold those with the worst between 1976 and 1996. The strategy generated an outstanding 23% annual return, beating the market’s 9.4% annual return, including dividends.
Piotroski wrote, “The evidence suggests that the market does not fully incorporate historical financial information into [stock] prices in a timely manner.”
The magic formula also works for any business in any country, whether the stock is relatively cheap or expensive. According to the Journal of Asset Management, the Piotroski Score remains a strong predictor of subsequent stock returns and future profitability in international markets over the 2000 to 2018 period. Across developed non-US countries as well as emerging countries, high-score businesses significantly outperform low-score businesses by about 10% per year. Furthermore, the Piotroski Score preserves its return-predictive power for all business sizes. The findings are consistent with the view that fundamental information is only gradually incorporated into prices by investors.
How do I calculate the Piotroski Score?
Calculating the Piotroski Score is easy. Anyone can do it. All you need are easy-to-find data from the business’ latest annual report and financial statements. A point is given to each of the nine fundamental performance signals that is met. Zero if not. The Piotroski Score is the sum of the nine individual signals.
Profitability signals
Positive return on assets: 1 point
Positive cash flow from operations: 1 point
Increasing trend in return on assets: 1 point
Cash flow from operations exceeds net income (earnings quality): 1 point
Leverage, liquidity, and source of funds signals
Decrease in leverage (decreasing long term debt): 1 point
Increase in liquidity (increasing current ratio): 1 point
Business did not issue shares in the current year (shareholder dilution): 1 point
Operating efficiency signals
Improvement in gross margins: 1 point
Improvement in total asset turnover (increasing revenue to average total assets): 1 point
What is Ginebra San Miguel’s Piotroski Score?
Ginebra San Miguel Inc. (PSE: GSMI), together with its subsidiaries, manufactures and sells alcoholic beverages in the Philippines and internationally. The business provides gins, brandies, wines, and distilled spirits, as well as vodka and rum. It is one of the largest alcoholic beverage companies in Asia.
GSMI fundamental performance signals
2020 return on assets (17.9%) > 0 : ✓ | 1 point
2020 cash flow from operations (₱5.18 billion) > 0 : ✓ | 1 point
2020 return on assets (17.9%) > 2019 return on assets (12.1%) : ✓ | 1 point
2020 cash flow from operations (₱5.18 billion) > 2019 net Income (₱2.76 billion) : ✓ | 1 point
2020 long term debt (₱674.0 million) < 2019 long term debt (₱2.62 billion) : ✓ | 1 point
2020 current ratio (1.9x) > 2019 current ratio (1.4x) : ✓ | 1 point
2020 change in the number of shares ( 0 ) : ✓ | 1 point
2020 gross margin (25.2%) > 2019 gross margin (26.7%) : X | 0 point
2020 total asset turnover (revenue to average total assets) (2.4x) > 2019 total asset turnover (2.1x) : ✓ | 1 point
GSMI 2020 Piotroski Score: 8
GSMI’s Piotroski Score of 8 indicates that the business is fundamentally strong despite the Covid-19 lockdown in 2020. The score decreased from 9 in 2019 due to just one operating efficiency signal that wasn’t met.
Nevertheless, GSMI’s Piotroski Score averaged 9 over the past five years from 2016 to 2020 and outperformed competitor Emperador (PSE: EMP) and the Asian beverage industry’s five-year average score of 6.
GSMI fundamental performance drivers
GSMI’s fundamental strength is driven by its strong return on assets and revenue growth signals, which places the business in the desirable top right performance quadrant compared to competitor Emperador (EMP) and peers.
Is Ginebra San Miguel under or overvalued compared to its peers?
GSMI is undervalued compared to its peers. The market may be underestimating or not be fully incorporating the business’ fundamental strength into its current stock price of ₱62.50 (May 6, 2021). GSMI’s price-to-book or PB ratio of 1.8x is below the Asian beverage industry’s average PB ratio of 2.2x.
Conclusion
The idea behind the Piotroski Score is very simple and effective — use historical financial statement data to separate winners from losers. Since not all undervalued businesses are fundamentally strong businesses, the Piotroski Score can help you find the diamonds in the rough and improve your investment performance.
Furthermore, CEOs, leadership teams, board members, and business managers of any business size, in any country, can use the magic formula to quickly assess their businesses’ fundamental condition, improve the signals, and build value.
The International Investor does not own shares of Ginebra San Miguel. This article is excerpted, edited, and sourced from the most recent company filings, S&P Global Market Intelligence, Stanford University Graduate School of Business, and the University of Chicago Graduate School of Business. The content is for general informational and entertainment purposes only and should not be construed as financial advice.