2 additional tests for picking stocks
Based on yesterday's Piotroski's 9-step tests, according to Harry Domash, 2 more tests are added:
#10) Total Liabilities/EBITDA: A gauge favoured by lenders, EBITDA measures a company's income before deducting for interest, taxes, depreciation, and amortization. Credit Analysts believe that EBITDA best measures a company's ability to service its debt. Lenders believe so strongly in this gauge that they often require debtor companies to maintain a specified total debt/EBITDA ratio. Failure to maintain the required ratio allows that lenders to call their loans, meaning that they want their money immediately, an action that can drive a company into bankruptcy. Of course, lenders would do that only as a last resort, since bankruptcy means that they'll end up collecting only a fraction of the money owed. Ratios of seven to eight, or higher, typically give lenders the option of calling the loans.
Credit analysts also consider the ratio a measure of a company's credit quality. Companies with ratios below 5 are considered investment quality, and these companies can borrow funds at lower rates than firms with higher ratios.
Analysts and lenders' reliance on the total debt/EBITDA ratio makes it more important than any other single factor, so I've given it more weight. Companies with investment quality ratios of 5 or lower get one point. Ratios above 5 and below 8 get zero. Ratios of 8 or above signal extreme danger, and I deduct a point.
I substituted total liabilities for total debt to ensure that the test considers all debt. Making that change does not significantly change the ratio values for most firms.
#11) Total Liabilities to Operating Cash Flow: I added this test to differentiate firms that generate significant cash flows compared to their liabilities (cash flow at least 25 percent of total liabilities) and are in little danger of insolvency as long as that condition persists. Add one point if the TL/OCF ratio is less than 4.
May be I should talk about the background of Piotroski's test. Piotroski is an accounting professor at the University of Chicago and in the early 1990s he had done a landmark study. He found that although the value portfolio outperformed the growth portfolio, it is not all the value stocks outperformed but just a few of them among the portfolio. More value stocks actually underperformed the market than outperformed. Piotroski wondered what's the relevance of a strategy that 'relies on the strong performance of a few firms, while tolerating the poor performance of many deteriorating companies'.
However, according to Mr Domash, these tests, even with the 2 tests he himself added, would break down when applied to very low-debt firms. Sometimes it gives failing scores to very strong companies that recently reported negative cash flow and earnings. So this detailed fiscal health exam should only be applied to high-debt firms (TL/E ratios of 0.5 or higher)
Reference: Fire Your Stock Analyst! Harry Domash, FT Prentice Hall, 2006, ISBN 0-13-935332-9
#10) Total Liabilities/EBITDA: A gauge favoured by lenders, EBITDA measures a company's income before deducting for interest, taxes, depreciation, and amortization. Credit Analysts believe that EBITDA best measures a company's ability to service its debt. Lenders believe so strongly in this gauge that they often require debtor companies to maintain a specified total debt/EBITDA ratio. Failure to maintain the required ratio allows that lenders to call their loans, meaning that they want their money immediately, an action that can drive a company into bankruptcy. Of course, lenders would do that only as a last resort, since bankruptcy means that they'll end up collecting only a fraction of the money owed. Ratios of seven to eight, or higher, typically give lenders the option of calling the loans.
Credit analysts also consider the ratio a measure of a company's credit quality. Companies with ratios below 5 are considered investment quality, and these companies can borrow funds at lower rates than firms with higher ratios.
Analysts and lenders' reliance on the total debt/EBITDA ratio makes it more important than any other single factor, so I've given it more weight. Companies with investment quality ratios of 5 or lower get one point. Ratios above 5 and below 8 get zero. Ratios of 8 or above signal extreme danger, and I deduct a point.
I substituted total liabilities for total debt to ensure that the test considers all debt. Making that change does not significantly change the ratio values for most firms.
#11) Total Liabilities to Operating Cash Flow: I added this test to differentiate firms that generate significant cash flows compared to their liabilities (cash flow at least 25 percent of total liabilities) and are in little danger of insolvency as long as that condition persists. Add one point if the TL/OCF ratio is less than 4.
May be I should talk about the background of Piotroski's test. Piotroski is an accounting professor at the University of Chicago and in the early 1990s he had done a landmark study. He found that although the value portfolio outperformed the growth portfolio, it is not all the value stocks outperformed but just a few of them among the portfolio. More value stocks actually underperformed the market than outperformed. Piotroski wondered what's the relevance of a strategy that 'relies on the strong performance of a few firms, while tolerating the poor performance of many deteriorating companies'.
However, according to Mr Domash, these tests, even with the 2 tests he himself added, would break down when applied to very low-debt firms. Sometimes it gives failing scores to very strong companies that recently reported negative cash flow and earnings. So this detailed fiscal health exam should only be applied to high-debt firms (TL/E ratios of 0.5 or higher)
Reference: Fire Your Stock Analyst! Harry Domash, FT Prentice Hall, 2006, ISBN 0-13-935332-9
posted by legomate at 1:55 am
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