DIY investing: how to use Altman’s Z score to value stocks
With stock markets at record valuation levels, the risk of a correction is higher, and investors holding financially strong stocks will likely see less of an impact than those investing in companies in financial difficulty. To eliminate these weak companies, DIY investors can use the Altman Z score which predicts the likelihood of an entity’s financial distress. Developed by Edward Altman, a professor at New York University, the score assesses a company’s credit health by analyzing five ratios based on the company’s financial statistics.
In this DIY series, we discuss how scoring works and the list of entities to consider, based on the score obtained using recent financial data.
The Z-score is a score assigned to a company using a formula based on the five important ratios; Z (score) = 1.2 * (working capital / total assets) + 1.4 * (retained earnings / total assets) + 3.3 * (earnings before interest and taxes / total assets) + 0.6 * (book value of equity / book value of total liabilities) + 1.0 * (sales / total assets).
The first element of the formula – working capital / total assets – measures the company’s net cash flow relative to total capitalization. The formula takes into account the decrease in current assets relative to total assets because it generally reflects the operating losses generated by the company.
While the second – retained earnings / total assets – measures cumulative profitability over time that reflects earning capacity, the third element – EBIT / total assets – measures the operational efficiency of the business.
The book value of equity / book value of total liabilities (measured by the book value of equity plus debt) identifies how much of the company’s assets can lose value before liabilities exceed assets and that the company does not become insolvent. Finally, the last component – sales / total assets – which is a standard measure of total asset turnover, illustrates the ability to generate sales of the company’s assets.
Typically, businesses with a Z score near or above 2.99 are considered to be in the safe zone, while those with a score below 1.81 are considered to be in the distress zone. According to a report by Edward Altman in 2000, in a series of tests over three decades (up to 1999), the model was found to be 82 to 94 percent accurate in predicting the fault (using a cut-off score 2.67) one year before the event.
Note that the Z-score was originally developed for manufacturing companies, but is applied to many industries to get insights.
Low Z Score Entities
Using the Capitaline database, we filtered stocks with the lowest Z-score among NSE 500 companies (excluding companies in the banking, finance and insurance segments) based on financial metrics as of March 31, 2021.
The company that tops the list is Tata Tele Maharashtra, a telecommunications service provider, which has been a loss-making company with negative net worth and high debt. Now the Tata Group is considering relaunching Tata Teleservices and that could be the reason the stock has hit the upper circuit several times over the past year.
Next in the list is Alok Industries, which was one of the first twelve accounts, released by the Reserve Bank of India for insolvency proceedings in June 2017. Take over by a consortium of Reliance Industries and JM Financial Asset Reconstruction in 2020 , the company has been in the line of cutting its losses.
Sun Pharma Advanced Research or SPARC, next on the list, is a subsidiary of Sun Pharma and is engaged in pharmaceutical research and development. The low Z score for the entity could be due to the nature of its business which has a long gestation leading to losses for some time.
One company evident in the list is Vodafone Idea, due to its inability to push through rate increases in a fiercely competitive telecommunications market and the issue of AGR. It has faced financial difficulties for several years now and has been one of the top companies with a low Z score. Recent government relief measures for the telecommunications sector offer a silver lining, however.
Suzlon Energy is another name on the list weighed down by debt problems since the start of the last decade, although it appears to be on the mend now. This is the case with GMR Infra.
Other companies with a low Z score come from industries that have been severely affected by Covid-19 – entertainment (Inox Leisure), airline services (Interglobe Aviation), and hotels and restaurants (Lemon Tree Hotel and Mahindra Holidays).
Applicability in the current context
For some of the companies on the list, the low Z score is in part due to a one-time Covid-19 event that had a significant impact on profits and profitability during FY21. However, the outlook is improving for the future, with restrictions easing and economies rebounding. This should be taken into account before making decisions based on this metric.