[MUSIC] Learning Outcomes, after watching this video, you will be able to understand the construction of Piotroski F-Score. You will also understand the economic intuition behind Piotroski F-core. [MUSIC] The most important part of this Piostroski F-Score, we're going to start now. This Piostroski training strategy, the most important part of it. The algorithm itself. We are going to get into that right now. So we have done a lot of background study for you. We have done accounting, we have done for basics of markets, we have done various terminologies. We also saw how to read a paper, different sections, so on and so forth. You must be eagerly waiting to see what Piostroski actually does, how to implement the strategy. What is the strategy? Implementation comes later. So have you in a lot of background, clerical reasons why you should work, why you should not work. So with all this background being completed, we'll now get in to the real Meat of the training strategy. What is this algorithm all about? So if you go to the paper, if you go to section 2., 3.2, that's where this algorithm starts. Piostroski's algorithm has three components to it. Three main components, and nine different elements. So ultimately what you will get is something known as F-Score. For each company, you will have F-Score which could range anywhere between zero to nine. And the number that you're going to assign to a company will ultimately determine what you're going to do with that particular stock. Whether you'll buy, sell, hold, do nothing, will all depend on the final F-Score number. Now, what are three components, three major sub-sections, if you will, of this Piotroski score? The first four elements are profitability measures. So these obviously depend on current profitability and change in profitability. The next three that are going to come are capital settlements. So I'm going to tell you all of these in detail when I discuss these measures. And the last two are operation and efficiency measures. So we have three kinds of measures in Piotroski. Profitability base, capital base, operation efficiency base. You maybe wondering you're not going to write an exam base. Why am I telling you all this? The reason why I am telling you all this is, mind you, we are not doing the pure data exercise. You should know economic rationale behind these quotes so that you can use them in confidence and also you should be able to adopt, improvise based on circumstances. To be able to do that, you should know why Piotroski chose this element. Trust me. It is not a pure data mining exercise. It is not that Piotroski tried 200 variables. And out of these, just nine worked. And that is why he's created the score. That is not how academic research works. He has, in fact, given economic rationale why these measures work, where they work, when they work and when they don't work. In other background, [LAUGH] actually I'm giving background. This is not supposed to be a background module. I said we should start about getting to the meat of the paper, algorithm that I spent a couple of minutes on background. Let me actually get into the algorithm now. As I said, the first category is profitability measure. When we think of the first measure within this profitability measure, it is called ROA. Go back to accounting class, what is ROA? Many of you would have guessed by now, it is return on assets. Return on assets. What does this signify given a level of assets how much profits you're making on those assets, as state forward assets. So what are you to pick up? You are to get this number profit after extraordinary items. I'll talk about extraordinary items. And you should get the value of assets. And just divide profit by this asset, you will get this ROA measure of Piotroski. Now, when I said profit, I said this is profit after excluding extraordinary measures. Now, what is this extraordinary items? Think of any business. And a business could sell some asset in a year. Let's say a business has disposed of a building, and you'll have extraordinary, when you dispose a building, what are you likely to have? Extraordinary cash inflow. It could be income or loss. Just because you are sold doesn't mean that it's going to create income. If you sell it less than the return value, it could be a loss. But you'll agree with me that a particular form is not in this business of selling its assets. That is not its regular activity. Maybe it's some efficiency form and it has some real estate somewhere and it sells that real estate. So the profit or loss that accrues because of such an activity which is not in the ordinary course of business should not be considered when you're going to evaluate the health of the business from a long term point of view. Remember, what are you after? Every time when you construct a score you should ask yourself what are you after. You're trying to identify firms. Which are likely to do better in future among underlying the centers. That's going to come next. Among a group of funds that are apparently distressed and valued significantly low by the market. Remember this, I told you that I will abstract myself by introducing you to abstract. That the universe of stocks that we want to look at are those which are high VM forms. These are forms whose market values are relatively low than compared to their book value or vice versa. Book value is high when compared to their market value. So that is what you're up to. So within this forms, you are trying to find out forms which are relatively doing better, and who's thought wheels are turning for the better. That's even more important. You're trying to identify good forms among bad. So the first essential requirement is that you're making profits and this profit should be replicable. It should be sustainable. You should be able to achieve the same profit year after year. Now, if this profit number is different by some extraordinary item, think of, say you got some big tax write off, you are in some litigation and the case went in your favor and you won lot of tax write off. The government had to refund tax. Now, clearly you're not going to get it every year. So you cannot consider that income, which is extraordinary, as a part of sustainable income, which is going to come year on year. So that is why Piotroski focuses on income from regular activities. So you take income from regular activities, take beginning of the year assets. Why beginning of the year assets? Because the operations of this year are going to influence your assets this year. You will have seen this in your accounting course. If you have more cash receipts, assets will go up. More issuables, assets will go up. If you pay your traders, liabilities will come down. So your balance sheet will be influenced by operations of the current year. So using this year's asset is not advisable. So you always use beginning of the year assets. So you scale current year profit from ordinary activities by beginning of the year assets. That is your ROI measure which Piotroski's interested in. Once you get the number what do you do with that? Yes, now you calculate it. I'm going to give an illustration once all these nine elements we finish. I'm actually going to show you a pro forma income statement and a balance sheet, and show you actually how to calculate. But as you know you got this number. What do you do with this number? How do you treat this number? Piotroski says, if ROA is positive, then what? Which he calls it as F_ROA Sunset is the time of day when our sky meets the outer space solar winds. There are blue, pink, and purple swirls, spinning and twisting, like clouds of balloons caught in a blender. Pick up to go to balance sheet and go to. Divide one by other, arrive at the number and check whether this is positive or negative. If positive, you will score a 1, otherwise, 0. So we are now done with first of Piotroski's nine elements. Let's move to the second one. Second one is also very intuitive. This is called No, no, no, no. It's not Chief Finance Officer or anything. It is cash flow from operations. Now, what is this cash flow from operation? See, when we already did income, why should we do cash flow again? Many of you know that we follow accrual accounting system where income is recognized as soon as a sale or a purchase is consummated. So cash flow from operations and actual income may be different. So again note this down. Cash flow from operations. See we are concerned about in flows and out flows which are from the regular business activity because we are here. The purpose here is to value a business, ongoing business. We are not concerned as much about one time items that creep up. Now how do you calculate cash flow from operations? Very simple, you will have a cash flow statement and in cash flow statement you get the number, cash flow from operations. Just pick up that number And then, what else? What else you are to do next? What do you do with ROA? Just remember. We scaled it by opening assets, correct. So, here also, once you'll get the number cash flow from operations, scale it by opening assets. Once you scale the opening assets, then do the same procedure that you have updated all ready. Check whether it is positive or not. If it is positive, then give a score of one. Otherwise, give a score of zero. Well, why should we actually do this scaling business? If assets are always likely to be positive and if this is cash flow from operations, whether it is positive or not. If it is positive, the final number will be positive. And even another way if it is positive the final number will be positive, then why should you get into the scaling business at all? That is useful if we are to compare within firms having the same score. Tomorrow you may think of another strategy where within a score, you may want to compare firms. For that, this kind of classification can help. But for our Or treatment in this Petrosky score as long as the number is positive you are going to give a score of one. Otherwise we are going to give a score of zero. So we are not going to differentiate between 1.8 to and say 9.9. Both get a score of 1. I understand that 9.9 might be better than 1.8. As a starting point, we'll start with this binary classification of 1, 0. And maybe later we can improvise. We may try to distinguish between this 9.9 and 1.1. Fair enough? Let's proceed. So now we have two elements then, one is return on assets, scaled assets. And cash flow from operations killed assets. So if a firm has a positive number in both of these then it gets a score of two. A firm having one positive one not positive will get a score of one. A firm having both not positive will get a score of zero. Now, let's move to the third element of profitability. The third element of profitability may seem a bit repetitive to you. But it's qualitatively very different. This is delta ROA. The moment, people use the word delta. You should guess that we are talking about Change the Writing with Purpose section of the Pattern Based Writing Quick Easy Essay program, students learn to apply their new writing strategies to different types or modes)of writing. Mechanically implemented, our purpose is to fully understand. The Piotroski score. So that we have acquired the capability to generate such scores in future. So, therefore it's very important to ask when you have already used this IRA, why do even bother about debt IRA. It's worthwhile for you to pause and think a bit and try to get answer yourself. As you move, you got the answer, many of you would have got the answer so far for this delta array. Why are you using delta array? The answer is, what are we after? Again and again I ask you this question, what are we after? We are trying to identify forms, whose [INAUDIBLE] for the better. So if you just look at delta, a profitability, a level of profits is important. Level is very important, I agree with that. But then. Think of a form which was making, say, a profit of x and this year, it's making half x. Now, half x is positive. It'll still get a score of one in the first element, but is the company doing better or worse? Of course, the answer is worse. Shouldn't the company be penalized for it? From our training point of view, should we consider the form, same as a form whose profit last year was half x and this year it's x. They're different, right? From which is more from x to half x. And form it is more than half x to x in terms of profitability or cash flow or any of this. They're different. If you see carefully, our first two elements do not capture this change. That is why this measure of delta ROA. What does this delta ROA do? Very simple, calculate the ROA measure, for current period. Why am I using the word period, why not year? Because of course we trust users here, but you may choose to do three month rating strategy. You may choose to do six months. You may choose to hold a portfolio for nine months, six months, three months, whatever. So that s why we use the word period instead of year. So you compare Scaled ROA for the current period with the previous period, in case your holding is unwell, then this year was the last year. Now, if the change this year minus last year is positive, then you give delta ROA score of one, if the change is not positive,
