Wesley and Tobias suggested improving two of the variables in the F-Score: cash flow from operations and equity issuance. They also rearranged the variables into different categories with a more intuitive format, which I will leave interested readers to read on their own in the book.
First, the cash flow from operations variable used by Piotroski is replaced with free cash flow divided by total assets, to incorporate the impact of capital expenditures. I am not sure if this is going to generate better results as maintenance capex is not differentiated from growth capex using free cash flow as a measure of profitability.
Second, the net equity issuance variable is substituted for the F-Score's existing equity issuance variable to include share repurchases. There are many companies which repurchase shares for the sole purpose of "funding" their stock option schemes. In situations like this, the individual's share of the "pie" (equity value divided by number of shares outstanding) does not become larger, but in fact may be smaller if share issuances exceed share repurchases. In any case the net change in shares outstanding should be the variable that investors should focus on, instead of either share issuance or purchases in isolation.
I agree with the use of the net equity issuance variable, but I am neutral on using free cash flow in place of cash flow from operations. As per my previous article, I will suggest some improvements to the F-Score of my own here.
First, there should be an absolute cut-off for certain variables such ROA, gross margin, asset turnover, gross ratio and debt-to-assets ratio. A stock with a perfect F-Score, but a gross margin of 5% and a debt-to-assets ratio of 300%, may have "improved" over the previous year, but surely should be not up for consideration.
Second, notwithstanding whether cash flow from operations or free cash flow is used in the variable ACCRUAL on the difference between earnings and cash flow, it will be a fairer assessment if the divergence between cash flow and net income is assessed on a multi-year basis.
Third, the F-Score screens for stocks with low P/B ratios in the bottom 20% of the market. I will suggest substituting the P/NTA ratio for the P/B ratio, since intangibles such as goodwill inflate the book value of serial acquirers.
Last, since there is a strong momentum element in the F-Score, by focusing on stocks which show signs of margin expansion and deleveraging, trailing 12 month and/or most recent quarterly numbers should be used where possible to capture the signs of positive momentum early. However, I emphasize again that the F-score may not be timely enough for contrarian value investing, since efficient markets should see share prices factoring in the improvement in operating metrics, before the F-Score Screen picks them up. This may be a reason why the F-Score has been seen to produce better results with small caps.
I will end my article with the comments I left on my previous article on the F-Score. There is nothing right orwrong with quantitative value investing, per se. However, one should understand the reasoning behind the quantitative tools and formulas before using them. Quantitative tools can be a useful starting point, but not necessarily an end point.