One problem with looking for bargains in the scrap yard of the stock market is that you will find many stocks that deserve to belong there.
These stocks may appear to be bargains, but they may be the kryptonite that will destroy your portfolio.
As many value investors find out over time, sometimes the stocks they buy is not worth even a fraction of what they paid for it.
How much would you pay for a stock if you knew that this company will go bankrupt in a year?
That is right! Not much!
But the sad truth is, just looking at the standard multiples tells you almost nothing about whether the business is a going concern.
Sure, you can look for working capital, liquidity ratios, etc to gauge some of this. Edward Altman, had a better way to calculate the likelihood of a company going bankrupt in the next 2 years. He called this method, the Altman Z-Score.
What is Altman Z-score?
Altman Z-Score measures the likelihood that a given company will go bankrupt in the next 20 years. It uses profitability, leverage, liquidity, solvency and activity to make the prediction. The Z-Score works well for industrial companies, but may not work as well for other companies.
The Altman Z-Score is
= 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
A = working capital/total assets
B = Retained Earnings / Total Assets
C = Earnings before interest and tax/ market value of equity/total liabilities
D = market value of equity/ total liabilities
E = Sales/Total Assets
Interpreting the Altman Z-Score
A score under 1.8 means that there is a very high probability of the company going bankrupt soon. A normal or high score (above 3.0) is harmless. It is a great idea to check the Altman Z-score to ensure that the stocks that otherwise look undervalued to us, are also able to survive.
Altman Z-Score Calculaiton
You can feasibly find all the data from the financial statements, and then compute the Altman Z-score. This can get tedious very quickly. Ideally you want your stock screener to calculate the Z-score for you.
Altman z-score gave us an early warning of the financial crisis in 2008. The median Altman Z-Score of companies in 2007 was 1.81, borderline. This shows a very bad credit rating. It was no surprise that the economy was in big distress at that time.