Developed by NYU Stern financial economist Edward Altman, the Altman Z-score predicts the likelihood of a company of going bankrupt within a two-year period.
Unlike the Piotroski F-score, which only ranges from 0 to 9, the Altman Z-score can potentially be any real number. Based on the distribution of Z-scores for Standard & Poor's 500 companies, technological companies have the strongest scores, implying a strong and stable business operation.
Altman’s financial indicator
Based on five ratios calculated from the company’s balance sheet, the Altman Z-score generates one value that measures the stability of the company. To calculate the score, Altman first computes the following five ratios:
- The company’s working capital divided by the total assets (WC/TA).
- The ratio of retained earnings to total assets (RE/TA).
- The EBIT/total assets ratio (EBIT/TA).
- The market value of equity divided by the book value of total liabilities (MVE/BVL).
- The company’s net sales over total assets (S/TA).
After calculating these ratios, Altman inputs them into his five-variable model to compute the Z-score of the company. The Z-score equals 1.2*(WC/TA) + 1.4*(RE/TA) + 3.3*(EBIT/TA) + 0.6*(MVE/BVL) + 1.0*(S/TA). Based on the output, Altman classifies companies as safe, in gray areas or in distress. Companies with low Z-scores are usually unstable and likely to go bankrupt. Such companies have an Altman Z-score less than 1.81, the threshold for distressed companies. On the other hand, companies whose Z-score is at least 3.0 are in safe zones.
Altman’s classification of companies is broad as there are only three classifications. According to his “zones of discrimination,” all companies with Z-scores between 1.81 and 2.99 are listed in gray zones, implying some financial stress. However, not all companies that have Z-scores in gray zones appear to face bankruptcy risk. For example, Southwest Airlines Inc. (LUV, Financial), one of many good Peter Lynch stocks, has high financial strength and profitability despite having a Z-score in gray zones.
The distribution of Z-scores for S&P 500 companies
The distribution of Altman Z-scores for S&P 500 companies is right-skewed with a mean of 3.70 and a standard deviation of 3.99. Based on Altman’s zones of discrimination, about 33% of S&P 500 companies are currently in distress. We can further divide the zones of discrimination as follows.
While 33% of S&P 500 companies have Altman Z-scores in distress zones, only 10% of companies are in moderate or severe distress, based on the newly defined distress levels. Forty percent of S&P 500 companies have mildly strong Z-scores, and 30% have highly strong scores.
However, the distribution of Z-scores for all S&P 500 companies has a slight drawback: Six companies have Altman Z-scores significantly higher than the mean Altman Z-score. When these six “outliers” are removed, the mean, the standard deviation and the skewness decreases to 3.37, 2.71 and 1.40. In other words, the distribution is less skewed to the left without the outliers.
Online media company has the strongest Z-score and high financial strength
Among the outlier companies, Facebook Inc. (FB, Financial) has the highest Altman Z-score of 42.51. While it is not a technology company per se, Facebook provides social networking services to a technological platform. The company currently has a financial strength rating of 9, implying a robust business operation.
In addition to having a high Z-score, the online media company has little or no debt. Facebook’s equity-to-asset ratio of 0.91 outperforms 94% of global Internet content and information companies. Historically, the company’s equity-to-asset ratio increased, i.e., the company gradually decreased its leverage.
Despite having slightly contracting operating margins, Facebook currently has higher operating margins than 92% of companies in its industry. With increasing gross margins and a higher return on invested capital compared to its WACC, the online media company has high upside potential in the short term.
Although no gurus made trades on Facebook during the recent quarter, Andreas Halvorsen (Trades, Portfolio) purchased 20,133,253 shares during the first quarter, when Facebook averaged $105.40 per share.
In addition to Facebook, one medical devices company and two semiconductor companies currently have an Altman Z-score higher than 20: Intuitive Surgical Inc. (ISRG, Financial), Linear Technology Corp. (LLTC, Financial) and Skyworks Solutions Inc. (SWKS, Financial). All three companies, like Facebook, have a financial strength rating of 9. Both Intuitive Surgical and Linear Technology have a Piotroski F-score of 8. While Skyworks Solutions only has an F-score of 7, it has seven good signs including expanding operating margins and comfortable interest coverage.
Walter Schloss and his cheap stock screener
One of Ben Graham’s successful students, Walter Schloss averaged 21% in annual returns during a 50-year period by investing in understandable companies that have little or no debt and are trading at cheap prices. GuruFocus implemented his investing strategy with the following filters:
- The company has an Altman Z-score of at least 2.99, i.e., the company is in safe zones.
- The company has interest coverage of at least 10.
- The price-to-tangible book ratio is less than 1.0.
- The stock price is at most 25% above its three-year low.
- In order for a company to be “understandable,” it should have a predictability rank of at least one star.
In addition, we will consider only U.S. companies and exclude all over the counter stocks.
Among the nine stocks listed on the Walter Schloss Screener, only Flowers Foods Inc. (FLO, Financial) has a predictability rank of at least two stars. The bakery company has the lowest Altman Z-score among the Schloss stocks, suggesting that the company’s business operation is relatively weak. On the other hand, Wireless Telecom Group Inc. (WTT, Financial) has the highest Z-score among the stocks listed on the screener.
The All-in-One Screener allows Premium members to look for stocks that meet the selected criteria. Additionally, users can implement one of the predefined screens including Walter Schloss. If you are not one of our Premium members, we encourage you to sign up for a free trial and explore the All-in-One Screener, one of our powerful features.
Disclaimer: The author does not own any stocks discussed in the article.
Start a free seven-day trial of Premium Membership to GuruFocus.
