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Altman Z Score Overview

The Z-score formula may be used to predict the probability that a firm will go into bankruptcy within two years.

Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company. - Wikipedia

Much like the Piotroski score, the Altman Z score too was formulated by a professor by the name of Edward Altman of NYU from the 1960’s. At that point in time, most of the public trading companies were in manufacturing. No Microsoft (MSFT) or Google (GOOG) at that time.

The Z score consists of 5 variables:

  • X1 = Working Capital / Total Assets
  • X2 = Retained Earnings / Total Assets
  • X3 = EBITDA / Total Assets
  • X4 = Market Value of Equity / Total Liabilities
  • X5 = Net Sales / Total Assets

Original Altman Z Score for Public Companies

The original model to calculate the Z score for public manufacturing companies is as follows.

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5

When Z is 3.0 or more, the firm is most likely safe based on the financial data. However, be careful to double check as fraud, economic downturns and other factors could cause unexpected reversals.

When Z is 2.7 to 3.0, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.

When Z is 1.8 to 2.7, the company is likely to be bankrupt within 2 years. This is the lower portion of the grey area and a dramatic turnaround of the company is needed.

When Z is below 1.8, the company is highly likely to be bankrupt. If a company is generating lower than 1.8, serious studies must be performed to ensure the company can survive.

Revised Altman Z Score

Chroma Investing wrote about a revised Altman Z score as the original might be under reporting bankruptcies among non-manufacturing firms.

...in subsequent studies, it was found that the original Altman Z score might be under reporting bankruptcies among non-manufacturing firms. Given that used correctly, it has a 80%-90% accuracy of predicting bankruptcy in the next year, Altman Z is a great tool, but it must be used correctly.

= 6.56*X1 + 3.26*X2 + 6.72*X3 + 1.05*X4

You will note that there is no X5 included in this version of the Altman Z score.It seems that including the X5 increased the likelihood of missing a potential bankrupt company for non manufacturing firms.

The revised Altman Z score cannot be used for Manufacturing companies, which requires the original Altman Z score. Nor can it be used for privately held, or publicly traded financial companies.

Also, be aware that companies with one time charge offs may show up negatively.

Finally the Z score cannot be accurately used for companies with less than $1 million in assets and reportedly more accuracy may be obtained by using companies with more than $100 million in assets.

The Altman Z score is probably not all that accurate in the small camp universe I usually tread. It has more narrowly defined uses than I originally realized.

Along with the revised Altman Z formula, the weightings were also adjusted.

When Z is 2.6 or more, the firm is most likely safe based on the financial data. However, be careful to double check as fraud, economic downturns and other factors could cause unexpected reversals.

When Z is 1.1 to 2.6, the company is probably safe from bankruptcy, but this is in the grey area and caution should be taken.

When Z is below 1.1, the company is highly likely to be bankrupt. If a company is generating lower than 1.8, serious studies must be performed to ensure the company can survive.

You can download the free Altman Z spreadsheet as well as check out the Altman Z screener.

Altman Z Screen Performance

If the Altman Z is to predict companies that are likely to go bankrupt within the next year or so, selecting a group of companies where the Altman Z score is above 3 should gather a list of fundamentally strong companies.

The screen assumes that it is rebalanced every 6 months. The results are all pre-tax so the overall results would be less.

From the looks of the results, the Altman Z score does a fantastic job of outperforming the market. 2008 results weren’t great but considering that no asset class or diversification saved any portfolio, I find the 2008 results to be acceptable.

Stock Ideas based on Altman Z Scores Above 5

Looking at the list of stocks in the list, a couple have been bought out, most, if not all, companies are fundamentally sound and the stock performances haven’t been too shabby either.

I’ve heard people mention that the Altman Z score can be used to find potential shorts, but from this short list, it may also be useful for finding buyout candidates.

The Altman Z score is something I’ll definitely refer to more often in my future analysis. When used correctly, it could save you from big headaches.

Grab your free Altman Z spreadsheet and check out the Altman Z screener. The premium stock valuation calculator will also include 10 years of Altman Z calcuations for both the original and revised formula.

Disclosure: No positions

Source: Using the Altman Z Screen Performance to Identify Stock Ideas