How the Z-Score Can Help Your Investment Returns

I recently came across an interesting article in the Financial Times called New study re-writes the A-Z of value investing based on thought provoking research from the investment bank Morgan Stanley.

They found that when buying undervalued companies based on valuation measures such as price to book value ("PB") and price to earnings ("PE") ratios, in economic downturns, returns are very dependent on the balance sheet financial strength of the company.

This makes intuitive sense and has been especially important in the current downturn because of the associated banking crisis.

Morgan Stanley used a measurement of financial strength called the Altman Z-score ("Z-score"). Which was developed in 1968 by Edward I. Altman, an Assistant Professor of Finance at New York University.

The Z-score is a combination of five weighted business ratios and can also be used to predict bankruptcy.

In a series of tests covering three different time periods over 31 years (up until 1999), the model was found to be 80-90% accurate in predicting bankruptcy one year prior to the event, with a error rate of 15-20%.

The z-score is calculated as follows:

Z-score = 1.2T1 + 1.4T2 + 3.3T3 +.6T4 +.999T5.

T1 = Working Capital / Total Assets.

T2 = Retained Earnings / Total Assets.

T3 = Earnings Before Interest and Taxes / Total Assets.

T4 = Market Value of Equity / Book Value of Total Liabilities.

T5 = Sales/ Total Assets.

And is interpreted as follows:

Z-score > 2.99 = Safe

1.8 < Z-score < 2.99 = Middle or grey

Z-score < 1.80 = Distress

Source:Wikipedia

Morgan Stanley ranked a basket of companies by their Z-scores and found that when they compared Z-scores with share price movements, companies with weaker balance sheets underperformed the market more than two thirds of the time.

They also found that a company with a Z-score of less than 1 tends to underperform the wider market by more than 4% over the year with a probability of 72%.

''Given the poor performance over the last year by stocks with a low Altman Z-score, the results of our back-test are now even more compelling than they were 12 months ago," argues Secker. "We calculate that the median stock with an Altman Z-score of 1 or less has underperformed the wider market by 5-6% per annum between 1990 and 2008."

When compound annual returns since 1991 were analysed, the results are more dramatic. On average, companies with Z-scores of less than 1 saw their shares fall 4.4 per cent, compared with an average rise of 1.3 per cent for their peers.

Only five of the 18 years did companies with a Z-score of 1 or less outperform the market in and this took place only in years with strong economic growth.

The study can be summarised as follows:

Unless you have a really compelling reason to buy, avoid companies with a Z-score of less than one like the plague.

I use the Z-score in my company analysis as an early warning signal. Should the Z-score be less that 3 I investigate further. However because I am relatively debt averse I seldom find reason to have to do so.

Tim du Toit is editor and founder of Eurosharelab. On his website he reveals what more than 20 years of equity investment have taught him - sometimes at considerable cost.

To discover how you can avoid costly mistakes and enjoy greater profits, sign up for his free newsletter at http://www.eurosharelab.com

Tags : Day Trade Alerts Home Remedies For Excessive Sweating Digital Desk Alarm Clocks Review Stock Analysis Software