How To Use The Altman Z-Score To Find Quality Companies
One of the famous valuation metrics that stood the test of time is the Altman Z-Score, which was formulated by Professor Edward I. Altman. The Altman Z-Score is a bankruptcy prediction model that predicts a company’s probability of going bankrupt within a span of 2 years.
The Altman Z-Score is used by many value investors as a tool to find quality companies. This is why I used this model in my Value Screen scorecard.
In this post, I’ll briefly discuss the logic behind this model and how you can effectively use it in spotting good investments.
So let’s begin.
How To Use The Altman Z-Score
This is the formula behind the model;
Altman Z-Score Formula:
Z = 1.2*X1 + 1.4*X2 + 3.3*x3 + 0.66*x4 + 1*X5
- X1 = Working Capital / Total Assets
- X2 = Retained Earnings / Total Assets
- X3 = EBIT / Total Assets
- X4 = Market Capitalization / Total Liabilities
- X5 = Revenue / Total Assets
Receivables and Inventories are the items that can be quickly turned into cash and these two items in the Balance Sheet is what drives a large working capital. A small Working Capital To Total Assets Ratio means that you have less assets that can be quickly turned into cash. The thing to remember is that a company should have enough assets that can be easily turned into cash in case the company undergoes financial distress.
Retained Earnings increases the equity of the business. If a company shows a constant decline of Retained Earnings To Total Assets Ratio, it might mean that the company is losing profits. In a worst case scenario, it might be a sign that the company is already failing or in the verge of bankruptcy.
The EBIT To Total Assets Ratio is a return measure just like Return On Assets. The difference is that we use EBIT instead of Net Income. By doing so, we now measure the return on capital. The metric is pretty straightforward; a low ratio means low operating efficiency and according to the model, this is a sign of a company that is most likely to fail.
The idea behind the Market Cap To Total Liabilities Ratio is that the market value of equity should always be larger than the total debt. If the debts of the company is larger than the market value of the company, then it’s a problem. In most cases, the market is just not bullish about the company so this should be carefully studied for.
The Revenue To Total Assets Ratio tells us how much the company invests in assets to generate Revenue. A low ratio is bad because it means that the company is investing too much in assets but isn’t generating enough sales.
What The Scores Mean
Here’s how to interpret the results;
- Z > 2.99; “SAFE” Zone (Healthy business)
- Z < 1.81; “DISTRESS” Zone (Troubled business)
- 1.81 > Z > 2.99; “GREY” Zone (Warrants more investigation)
Using the Altman Z-Score will help us find quality companies to reduce our investment risks. Focusing on companies in the safe zones and finding the undervalued ones will give us a higher probability of success.
That’s the reason why I included this model in my value screening scorecard. As much as possible, I like to buy quality companies that are trading below the intrinsic value. The Altman Z-Score does the job well.
You can use this Altman Z-Score calculator I’ve made available for download to help you in your value screening process. You can download it by clicking the link below.
Download Altman Z-Score Calculator
If you find the post and spreadsheet useful, I would love to hear your thoughts by leaving your comments below.