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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 (NASDAQ:MSFT) or Google (NASDAQ: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