I have been experimenting with a quantitative model refered to as Z-Score. Think of every company as a single straw of hay, and among them, there are a few needles – the companies we want to target. We have neither the time nor the energy to sift through all the hay manually, so we construct a model and use data analysis to build ourselves a magnet. This magnet attracts those interesting companies and brings them to the spotlight for further investigation.
By incorporating these 15 key financial ratios and comparing companies using standardized Z-scores, the Alternative Z-Score Model provides a comprehensive and objective assessment of a company’s financial health and market perception.
So what exactly is a z-score?
Z-score is a statistical measure that quantifies the distance between a data point and the mean of a dataset. It’s expressed in terms of standard deviations. It indicates how many standard deviations a data point is from the mean of the distribution.
Forumla : z = ( x – μ ) / σ
- z = Z-score
- x = the value being evaluated
- μ = the mean
- σ = the standard deviation
How do I use this model? First, you need to dataset, a dataset is usually companies thats indexed by its industry, sector, size, region or even mix and match these factors to create your own custom peer groups.
For example, let’s say you want to compare tech companies. You can use the model to analyze all the companies in the technology industry and see who’s crushing it and who’s falling behind.
For each indicator, we calculate the mean and standard deviation of the values across all companies in the peer group. We then adjust the machine to divide the ratios into two groups: one where a higher value is preferred and another where a lower value is desired. This is done to ensure that points are awarded correctly.
Load the targets into the machine and let the machine go Brrr.
Next, we assign scores to each company for each indicator based on its Z-score. A Z-score close to +1 indicates significant outperformance, while a Z-score close to -1 indicates significant underperformance. Z-scores close to zero indicate performance that is close to the average of the peer group.
Then, we iterate over each company and indicator, assigning points based on how well they perform compared to the group’s average. Likewise, we deduct points if they underperform compared to their peers.
What we now get is a hand full of scores, where we dont just measure one value rather we act as a talent show we just dont pick a winner becuase they excel in one area rather we look at the holistic view they need to perform well in all areas for us to take notice.
Below is a little bit of information of each of those 15 finacial ratios used in my Z-score model.
Return on Equity (ROE)
Formula: ROE = Net Income / Average Shareholders’ Equity
ROE shows how effectively a company uses its equity capital, i.e., the capital base contributed by shareholders, to generate profits.
A high ROE indicates that the company has the ability to reinvest profits in a profitable manner and provide a good return to owners on their invested capital.
ROE is a popular ratio for comparing profitability between different companies.
Return on Assets (ROA)
Formula: ROA = (Operating Income + Financial Income) / Average Total Assets
ROA provides an indication of how efficiently a company generates returns from all the assets it has at its disposal, regardless of whether these assets are financed with equity or debt capital.
A high ROA signals that the company has the ability to utilize its total resources, both tangible and intangible, in a profitable way.
Return on Invested Capital (ROIC)
Formula: ROIC = Operating Income / (Total Equity + Interest-Bearing Debt)
ROIC focuses specifically on the return on capital actually invested in the company’s core operations, after deducting any non-interest-bearing short-term liabilities.
This makes ROIC a useful ratio for comparing profitability between capital-intensive companies with large values tied up in inventory and fixed assets, for example.
An ROIC above the company’s cost of capital indicates that value is being created for shareholders.
Gross Margins
Formula: Gross Margin = (Revenue – Cost of Goods/Services Sold) / Revenue
Gross margins show the surplus a company generates from its goods or services after deducting the direct costs associated with producing them.
High and increasing gross margins may indicate that a company has a strong market position with pricing power or efficient cost management in production.
Low and declining gross margins, on the other hand, can be a warning sign of increased competition or inefficiency.
Operating Margins
Formula: Operating Margin = Operating Income / Total Revenue
The operating margin shows the proportion of total revenue remaining after all operating expenses in the form of sales, administration, and R&D expenditures.
A high and increasing operating margin indicates a scalable business with good cost controls, while a low and declining operating margin may indicate challenges in keeping operating expenses down.
Profit Margins
Formula: Profit Margin = Net Income / Total Revenue
The profit margin, also known as the net margin, is the bottom line after all revenues and all expenses, including taxes and financial items.
It shows the proportion of total revenue remaining as net profit for shareholders.
A high and increasing profit margin over time is a strong indicator of a profitable business.
Declining profit margins, on the other hand, may indicate problems in the business or industry.
Efficiency Ratios
Revenue Growth
Formula: Revenue Growth = (Total Revenue(t) – Total Revenue(t-1)) / Total Revenue(t-1)
Revenue growth measures the percentage change in a company’s total revenue compared to the same period in the previous year.
This is a key ratio for assessing the rate at which a company is growing in terms of revenue over time.
High and sustained revenue growth may indicate a growing market, increased market share, or successful launches of new products and services.
Low or negative growth, on the other hand, may point to challenges in the form of reduced demand, lost market share, or other internal or external problems.
Asset Turnover
Asset turnover shows how efficiently a company generates revenue from the total assets it controls, such as machinery, buildings, inventory, etc.
Formula: Asset Turnover = Total Revenue / Total Assets
A high asset turnover indicates that the company has successfully utilized its capital assets to drive sales.
A low and declining asset turnover, on the other hand, may indicate overcapacity, inefficiency, or outdated assets.
Inventory Turnover
Formula: Inventory Turnover = Cost of Goods Sold / Average Inventory Value
Inventory turnover measures how many times during a given period (usually a year) a company’s inventory is sold and must be replenished on average.
A high inventory turnover means that inventory levels are efficiently matched to sales volumes and that inventory holding costs can be kept down.
A low inventory turnover, on the other hand, may indicate difficulties in selling finished goods or an overextended inventory with tied-up costs.
This ratio is particularly useful for retail and manufacturing companies.
Together, these three ratios provide insight into how efficiently a company runs its operations, utilizes its assets, and grows in terms of revenue. Stable or increasing levels over time are usually a sign of good profitability and growth potential.
Cash Flow Analysis
Operating Cash Flow
Operating cash flow shows the actual inflows and outflows of cash from ongoing operations during a given period, after interest expenses and income taxes have been paid.
This cash flow fundamentally reflects the company’s ability to generate ongoing positive cash flow to finance investments and repay debt.
A consistently strong operating cash flow is an indication of a sound and cash-generating business.
Free Cash Flow
Formula: Free Cash Flow = Operating Cash Flow – Capital Expenditures
Free cash flow is calculated by subtracting the period’s capital expenditures from operating cash flow.
Free cash flow represents the remaining cash available to carry out value-creating activities such as reinvestment, returns to shareholders, or debt repayment.
A positive and increasing free cash flow is a strength indicator for companies.
Balance Sheet and Debt
Debt-to-Equity Ratio
Formula: Debt-to-Equity Ratio = Total Debt / Total Equity
The debt-to-equity ratio shows the relationship between a company’s total debt and its equity, providing an idea of the financial leverage effect.
A higher debt-to-equity ratio means that the business is financed to a greater extent with borrowed capital, which can be risky if profitability declines.
On the other hand, a certain level of leverage can also be used to increase return on equity in good times.
This ratio should be interpreted in context based on industry practice and the company’s maturity phase.
Valuation Ratios
P/E Ratio
Formula: P/E Ratio = Share Price / Earnings per Share
The price per share divided by earnings per share gives the P/E ratio, which is one of the most popular valuation ratios for stocks.
A high P/E ratio indicates that the market expects high earnings growth in the future, while a low P/E ratio may indicate that the stock is undervalued relative to earnings.
The P/E ratio should be compared with similar companies in the same industry.
P/B Ratio
Formula: P/B Ratio = Share Price / Book Value of Equity per Share
The P/B ratio compares the share price with the underlying book value of equity per share according to the balance sheet.
A P/B ratio below 1 may indicate that the stock is trading at a discount relative to book value.
The valuation level should be related to the industry and the type of assets the company has.
EV/EBITDA
Formula: EV/EBITDA = Enterprise Value / Earnings Before Interest, Taxes, Depreciation, and Amortization
This valuation ratio compares the company’s total value (share price x number of shares + debt – cash) with its operating cash flow before depreciation and amortization (EBITDA).
EV/EBITDA is a capital structure-independent measure that facilitates comparisons between different companies and industries.
Large dispersion within the industry may indicate over- or undervaluation.
