How to Find Value Stocks With the Z-Score and Piotroski Scale

This column was originally published in two parts on RealMoney: part one on Feb. 21, 2008, at 3:44 p.m. EDT and part two on Feb. 22, 2008, at 2:44 p.m. EDT. Both parts are being republished in one column as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Two Ways to Check Your Stocks' Credit Scores

If you watch any television at all, you probably can't escape those unbelievably obnoxious commercials for credit reports . I mean, I feel for the guy in the ad, working in a tourist-trap fish joint, living in his wife's parents' basement and driving a beater, all because he failed to keep track of his credit score , but enough already!

Obnoxious as they are, the commercials do make a good point. Keeping track of the changes in your credit score is a good idea, and everyone should do it. Tracking the changes can help you see what you are doing right, as well as wrong, with your financial habits. Now, if it makes sense for your personal finances, doesn't it make sense to do the same with your stock portfolio?

It makes even more sense when dealing with value and distressed stock situations. Legendary value investor Chares Brandes did a study a few years ago that tracked the results of what he called the "falling knife" stocks. The study (along with a lot of other great financial market research papers) can be found by going to the Brandes Web site and clicking on the "Institute" pages.

The study has two very important findings. Brandes defines a falling knife as a stock that has fallen 60% or more over the past 12 months. Flying in the face of the old Wall Street adage, the study concludes that for a long-term investor, buying these stocks is actually a very good idea. In fact, for long-term investors who are willing to hold them three years, they more than doubled the performance of the market as a whole.

The other important finding was not really a surprise. The biggest drag on performance for the falling knives, as a group, was bankruptcy. Over the 20-year time period encompassed by the study, almost 10% of the companies ended up filing bankruptcy . Imagine what would happen if we could eliminate that dangerous 10% and concentrate on the survivors? Performance would increase dramatically!

The simple truth is that we can. By applying simple credit-scoring systems to our collection of battered beauties, we can cull the wounded and concentrate on the likely survivors. To accomplish this, I use two credit-scoring methods that assess the health of a company's balance sheet and likelihood that the company will survive and even prosper going forward.

The first of these is the Altman Z Score. The Z Score was developed back in the 1960s by NYU Stern Business School professor and distressed-securities guru Edward Altman. The score uses five common financial ratios to rate each company. A score above 3 indicates that the company is healthy and in no danger of bankruptcy. A score below 1.8 is a prediction of imminent collapse.

In real world practice, this score has been very accurate, predicting as much as 72% of corporate bankruptcies on the basis of the Z Score. There are numerous Web sites where inputting a few simple numbers from a company's balance sheet and income statement will automatically generate this measure.

The other score I use was developed by Professor Joseph Piortroski of the University of Chicago. He noticed that although distressed stocks that sold below book value did outperform the market over time, most of the outperformance came from a handful of stocks. He did a study to see if the factors relating to outperformance could be isolated and identified. He found that, indeed, he could measure not only the health of the balance sheet but the prospects for improvement, using nine financial inputs. A description of the model is available here.