Altman Z score – Help Protect your Back Side
Posted on | December 24, 2009 | No Comments
Think of this post as a Christmas present, even though this knowledge has been around for a long time. When you are slumming in the Low Book Value world you need to make sure you are protecting your down side. After all there is a reason most companies have been humbled by the market. The Altman Z-score can be a tool to help you avoid the worse of the companies in the value world.
In 1968 a Professor named Edward Altman devised a formula for predicting bankruptcy. Initially, the Z score was found to be 72% accurate within two years with a 6% false positive rate. In subsequent testing, it was found to be 80-90% accurate within one year with a 15-20% false positive error rate. In other words, if a company fails this test, you are treading way over your head, unless bankruptcy is your desired outcome. In which case you may have found a good shorting opportunity.
For the math avoiders in the group here is a website with an Altman -Z calculator. I don’t use things like this because I am never sure of their accuracy, but it may be better than trying to calculate the Z score on your fingers.
Here is the math that goes with the Altman Z score. Altman’s formula is a weighted sum of different elements, which are as follows.
T1- Working Capital/Total Assets
T2= Retained Earnings/ Total Assets
T3- Earnings before Interest and Taxes (EBIT)/ Total Assets
T4- Market Value of Equity/Book Value of Total Liabilities
T5- Sales/Total Assets
So the actual formula is Z= 1.2T1 + 1.4T2 + 3.3T3 + .6T4 + .999T5.
I always check companies before I invest. I have been scared off more than once by a low Z score. What is good and what is bad?
Greater than 3.0 is considered safe.
1.8-2.99 Gray Zone
Below 1.8 Distress Zone. Bad.
I have added an update to the Altman Z score, which before you use it for investing you should check out at Altman Z Score Redux.
Comments
Leave a Reply