We’re talking about cheap stocks. Earlier research showed that low price-to-book stocks did better than the market. As a group. Not one on one. Only 44 percent of low price-to-book stocks did better than the market. But the group did much better. That means a small number of low price-to-book stocks were doing way better than the market. So much better that they managed to more than make up for the majority of low price-to-book stocks that weren’t doing well.
Let’s stop and think for a second. You often hear that low price-to-book stocks do better than the market. That’s kind of true and kind of not. It depends on how you ask the question. As a group they do better. But if you pick any one of them at random – then it’s not true. So buying 100 low price-to-book stocks works well. Buying just 1 low price-to-book stock doesn’t. In fact in about 11 times out of 20 you’ll do worse than the market if you just pick one low price-to-book stock.
This accounting professor wanted to solve that problem. And he did. He called it the F-Score.
The idea is simple. He didn’t start by using statistics to find the best set of rules. Instead he just picked 9 common sense rules value investors use in the real world. He didn’t do anything with their weights. That means he didn’t make one of them count for 2 points and another count for 10 points. Every question is worth 1 point. And there are only two ways to answer a question. True or false. Yes or no. One or Zero. That’s it.
I put a link in the “notes” section of the website to a page that explains the F-Score and how to figure it for any stock you’re looking at.
You should click on that link and read the page. Sometimes it’s easier to read things than hear them. Especially when we’re talking about a list of 9 different questions.
The F-Score is a checklist. You go through 9 different questions and check off the ones you answer “yes” to. Then you add up the “yeses”. And that’s the stock’s F-Score.
The first question is whether the company’s most recent annual earnings are positive or negative. If earnings are positive give the stock one point. If earnings are negative give the stock zero points. You can adjust for “extraordinary items” if you want to. But that gets us into the issue of exactly what an extraordinary item is. For now let’s just pretend the question is whether earnings are positive or negative. We can talk about extraordinary items later.
The second question is cash flow from operations. Is it positive or negative? If it’s positive give the stock one point. If it’s negative give the stock zero points. You can find the company’s cash flow from operations on the cash flow statement. It is usually the first of three totals. Negative numbers are shown in parentheses.
The third question is whether the company’s return on assets is higher this year than last year. It’s easy to figure out a company’s return on assets. Just take earnings and divide by assets. The professor used starting assets. That means you take this year’s income and divide by the total assets listed at the end of last year.
Financial reports sent to the SEC make this easy for you. If you check the balance sheet, income statement, and cash flow statement, you’ll notice they show you last year’s numbers too. So you can get a company’s return on assets without having to go back to the past year’s 10-K. Just open up this year’s 10-K find the net income number and divide by last year’s total assets. That’s this year’s return on starting assets.
Now go back and get last year’s 10-K. Do the same thing there. Take net income and divide by starting total assets. Then compare this year’s number to last year’s number. If this year’s return on assets is higher than last year’s give the stock one point. If it’s the same or lower give the stock zero points.
Question #4 is about earnings quality. Is the company’s cash flow from operations higher than its net income? If operating cash flow is higher than net income give the stock one point. If not give the stock zero points.
Companies with higher net income than operating cash flow have low quality earnings. We don’t want earnings to come from one time events. And we don’t want earnings that we can’t turn into cash. That’s the idea behind this earnings quality check. It’s a good idea. Always look for cash earnings. If the earnings don’t give you cash – how real are they? You can’t pay bills with earnings. You can only pay bills with cash. You can’t pay dividends with earnings. You need cash. So always look for earnings backed up by cash flow.
Question number 5 is about leverage. Take long-term debt and divide by total assets. Then go back one year and do the same thing. Is leverage higher or lower? If it’s lower give the stock one point. If it’s higher give the stock zero points.
This is a tricky question. It’s important, but the way the question is phrased in the professor’s paper makes it hard to apply this question the same way to all stocks.
For example: Do we count the current portion of long-term debt as part of long-term debt? I think we should. But do all companies clearly separate the current portion of long-term debt from other types of short-term debt? I’m not sure we can count on that. But we can try our best. My suggestion is to count everything that looks like debt. That means the “long-term debt” line and the “current portion of long-term debt” line plus anything else with the word “debt” in it, like anything called “short-term debt”.
Another option would be the simple leverage ratio of assets divided by equity. I always look at total assets divided by tangible equity when I think about leverage. But because that isn’t how this question was designed, I don’t use it as part of the F-Score. It’s a good idea, but it’s not part of the professor’s paper. So let’s stick to using only “debt”. Try your best to match the way the question was designed. We’re trying to measure debt divided by average total assets.
That brings us to another point. You’ll notice that for return on assets we used starting assets. But now the professor has us using average assets when we figure out the leverage ratio. Does it matter?
Not really. Most of the time little changes like this don’t matter. But it doesn’t hurt to stick with the original rules. If nothing else it will at least force you to treat each stock the same. That’s important. You don’t want to go back and forth on how you figure a stock’s F-Score. You want to use the same rules every time.
You might want to set up a spreadsheet in Microsoft Excel to make sure you do things the same way every time.
Next is question number 6. This is the change in the current ratio. A stock’s current ratio is current assets divided by current liabilities. If this year’s current ratio is higher than last year’s give the stock one point. If this year’s current ratio is lower than last year’s give the stock zero points.
Question number 7 asks about the number of shares outstanding. In his paper, the professor wrote “I define the indicator variable EQ_Offer as equal to one if the firm did not issue common equity in the year preceding portfolio formation”. To make this easier on you I suggest you just check the number of shares outstanding on the cover sheet of the 10-K. If the number of shares is higher give the stock zero points. If the number of shares is lower this year than it was last year give the stock one point.
Question number 8 is the change in gross margin. If you look at the income statement you will see a line called “gross profit”. If you don’t see a line called gross profit you can work backwards by subtracting the “cost of goods sold” line from the “net revenues” line. The words used might change from company to company. The gross margin is gross profit divided by net revenues. Figure out the gross margin for this year and last year. If this year’s gross margin is higher give the stock one point. If last year’s gross margin is higher give the stock zero points.
The last question is about asset turnover. Find the sales number on the income statement and divide it by starting assets. Once again that means the total assets shown at the end of last year. The ratio you get from dividing sales by assets is the asset turnover ratio. If this year’s asset turnover ratio is higher than last year’s give the stock one point. If it’s lower give the stock zero points.
After answering all 9 questions add up the points. Think of F-Scores as being on a bell curve. Scores in the middle like 4,5, and 6 are common. Scores of 9 or zero are rare.
I said don’t buy stocks with F-Scores of 3, 2, 1, or zero. I’ll stand by that.
Are really high F-Scores important? Maybe. If you’re looking at low price-to-book stocks they are. If you’re looking at stocks because you like their free cash flow, don’t worry about the F-Score as much. The Z-Score is more important for stocks like that, because your big risk is bankruptcy.
The F-Score helps with companies that are cheap but don’t look like they’re headed in the right direction. If you can find low price-to-book stocks with high F-Scores you can buy some great bargains as they’re turning their business around.
The better known the stock is the less helpful the F-Score becomes. The F-Score works best on small stocks that aren’t covered by analysts and aren’t owned by mutual funds.
So does Microsoft’s F-Score matter? I wouldn’t spend a lot of time worrying about it. The F-Score helps most when information is scarce. Look for stocks with market caps under $100 million. Look for over the counter stocks. And look for stocks with low price-to-book ratios. Those are where the F-Score can do the most for you.
Thanks for your question. I’ll talk about the Z-Score tomorrow.
That’s all for today’s show. If you have a question you want answered call 1-800-604-1929 and leave me a voicemail. That’s 1-800-604-1929.
Thanks for listening.