Piotroski only looks at stocks in the lowest third (tertial) of the market cap population (33% of all market caps) and the highest fifth (quintile) of the book-to-market population. He focuses on companies that are small to medium and are financially distressed and also have a very poor coverage by analysts (ideally zero analysts).
As a consequence we will at first limit our population by the following conditions
- Lower 1/3 of all market caps
- Top 20% of book-to-market stocks
- Zero analyst coverage or coverage older than 1 year (or alternatively use stocks with less than 10 analysts coverage)
We therefore sort all stocks by market cap and only keep the lower 1/3rd of that population (lower 33%). Similary we sort all stocks again by book-to-market and only keep the stocks with the highest book-to-market of the the top 1/5th (top 20%)!
What is the book-to-market? The book-to-market is the inverse of a more well known parameter called price-to-book.
Piotroski's F-Score is calculated by summing over 9 parameters.
1 : ROA > 0
The return on assets (ROA) is a ratio that measures the dollars in net profit a business generates per dollar of assets it owns. If it is positive F_Score(ROA) = 1 otherwise 0.
2 : CFO > 0
This measure is the ratio of operating cash flow divided by total assets. If it is positive F_Score(CFO) = 1 otherwise 0.
3 : ∆ROA > 0
Is the year-2-year change in ROA positive? If this is positive the F_Score(∆ROA) = 1 else 0.
4 : Accrual CFO > ROA
Is CFO greater than ROA? If it is greater then F_Score(CFO>ROA) = 1 else 0.
5: ∆LEVER ≦ 0
It is the historical change in the ratio of total long-term debt to average total assets. An increase in this ratio is negative and therefore F_Score(∆LEVER)=0 otherwise 1.
6: ∆LIQUID > 0
It measures the change in the current ratio between current and previous year. An increase in the current ratio is positive and therefore F_Score(∆LIQUID)=1 otherwise 0.
7: ∆EQ_OFFER > 0
An increase in the floating number of shares, i.e. an increase in common equity, in other words a dilution of share holder value is negative and if the floating number of shares has increased since 1 year prior the F_Score(∆EQ_OFFER) = 0 otherwise 1.
The year-to-year change of the ratio of gross margin and total sales defines this measure. If the change is positive then F_Score(∆MARGIN) = 1 else 0.
This measure is defined as the change in the company's current year asset turnover ratio, which is the ratio of total sales and beginning of the year total assets. A year on year inrease is positive and we set the F_Score(∆TURN) = 1 otherwise 0.