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A Closer Look at the Z-Score

David Chulak

29 followers
I wrote an article the other day regarding the F-Score, a method to discover stocks that had been depressed, but had characteristics which showed improvement (or the lack thereof), leading to less risky investments and actually increasing the potential return. Today, I want to discuss the “other” score shown on the GuruFocus website called the Z-Score.

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If you click your mouse on the “?” next to either score, you will get a great article on both subjects that cover the scoring quite well.

When it comes to finance and/or accounting, it will soon be discovered that to a great extent, it is more art than an exact science. As investors, we know that manipulation can take place on numbers and that financial officers can do some crafty calculating without doing anything illegal. Similarly, both the F-Score and Z-Score are tools, but they are not an exact science. They don’t claim to be. In the case of the Z-Score that we are studying, you will discover a high predictive accuracy. With that said, none of these methods should be used by themselves to make a decision regarding an investment. It is recommended that they be kept in your toolbox of investment techniques as one thing to study.

It should also be noted that there are other models for predicting companies that will become insolvent, or soon to be. Edward Altman, a few years after this famous Z-Score, produced the Zeta Score which professes to be even more accurate. There is also the Springate Score, Fulmer Score and CA-Score and others. In a study done by W. Beaver in 1967, he concluded that the one best ratio to use as a predictor was cash flow to debt. Altman concurred with that, but still had overall better results. We may possibly go over these at another time in another article.

Note that the original testing showed an accuracy of 72% for discovering a company that might file for bankruptcy. Subsequent testing has indicated a higher accuracy between 80% up to 90%. The exact number is not important. It has stood the test of time, over 40 years and still going.

The Z-Score or Altman Z Score was produced by Edward I. Altman in 1968. If any company had a score less than 2.675, it was considered to have failed and became a candidate for bankruptcy and/or merely a very distressed stock. If that was all you knew about the Z-Score, which company below would you choose?

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The only passing company in this list is RadioShack (RSH), so if you simply made a decision based upon the number shown on the screen, you would conclude that Radio Shack is the safest of the listed investments. For those of you that have an affinity for Mr. Buffett, you may want to call him and give him the bad news. (Please don’t!)

The original produced model of the Z-Score was mostly concerned with manufacturing-type companies and there are actually different models or Z-Scores for private companies or non-manufacturing companies. Most websites that do report the Z-Scores use the original methodology without adjustments for the type of company. See the “?” article next to the Z-Score on this website to see the different scoring for the types of companies. It’s a great article. It must be stated that there are weaknesses to the scoring. That is, financial companies as shown in the table above do not fare well. This is mostly due to off balance sheet items. So use these numbers with caution, but it’s doubtful that Berkshire Hathaway (BRK.A)(BRK.B) or Capital One (COF) will be going anywhere anytime soon. The scoring does not also work very well with newer companies or those with with none or little earnings. Also consider onetime items that may skew a Z-Score quite easily, so look for that possibility.

The most important thing to remember is that the Z-Score is somewhat like a balance sheet and is a picture in time. A balance sheet becomes much clearer when compared to other years. The Z-Score is no different and is best used when compared with previous years or previous quarters. It’s the trend of the number that counts the most. In an article by John R. Grabski from 2008 called “The Dynamic Z-Score,” Grabski writes:

“…considerable power and insight can be gained by evaluating the behavioral trend of the Z-score (Carton and Hofer, 2006). That is, the direction and slope of the Z-score versus time provides more insight into firm viability than one discrete measure of the score itself. Put simply, a low but steadily inclining Z-score provides more useful information than one specific snap shot in time since it provides insight into the future direction of the firm. A recent study performed by Carton and Hofer (2006) for example demonstrates that observing the change to the Z-score provides five times more information than when compared to a snapshot of one moment in time. Indeed, such a scenario provides some indication of the position of the firm in the subsequent period for which the analyst is concerned. For example, a trailing twelve month or twelve quarter Z-score trend line updated each month provides the analyst with powerful insight into the likelihood-of default that may far exceed the single moment in time snapshot that pays no respect to either the direction or the trajectory of company performance.”

Looking at one number on a screen doesn’t tell the whole story. It’s a beginning point. If you see a low Z-Score number, find out what’s going on no matter how big the company or strong you believe it to be. Just ask those that owned Enron.

Disclosure: No positions on any stocks mentioned in this article.

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

Rating: 4.0/5 (9 votes)

Comments

gurufocus
Gurufocus premium member - 2 years ago
thanks for another great article, David!

A clarification here. The Z-score for Berkshire or Capital One are not calculated, therefore they are empty in the statistics box. But they are not zero if we do calculate.

We don't calculate Z-score for financial companies. As you understand, Z-score does not work well for financials.

Please leave your comment:


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