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Wednesday, June 5, 2019

Stock market tip: Avoid losing big from stock tips using Altman Z-Score kcchongnz

Author: kcchongnz | Publish date: Tue, 4 Jun 2019, 9:13 PM

This is a free tip in the stock market.

Rule No. 1: Never lose money

Rule No. 2: Never forget Rule No. 1

I have been reiterating that in investing, we must take care of the downside first before looking at the upside so that the chance of facing permanent loss of capital is slim. The permanent loss of capital can be split into three sets of risks: valuation risk, business/earnings risk, and balance sheet/financial risk.


Investors tend to ignore these risks when chasing stock tips, rumour and hot stocks, especially recommended by analysts, investment bankers, insiders and syndicates, famous investors, friends and relatives, and tooth fairies, and ended up losing big time in the stock market. If you have been one of them and have been reading and following some continuous touting of stocks in i3investors, you would agree with me, don’t you?

Here, I would like to introduce to you one effective way how to avoid this pitfall by doing some checking yourselves before sinking your money in those stocks touted by other people as above, the use of the good old Altman’s Z-Score to measure the bankruptcy risk of a public listed company. Afterall, if a company bankrupt, or perceived to have high bankruptcy risk, there is where investors will lose big or all their investment in the stock of the company.

The Altman Z-Score was devised by Edward Altman, the New York University professor as a statistical tool used to measure the likelihood that a manufacturing company will go bankrupt. Though Altman devised the Z-Score in the 1960s, the notion of trying to predict which companies would fail was far from new at that time. However, Altman added a multivariate analysis to the mix of traditional ratio-analysis techniques such as current and quick ratio, and this allowed him to consider not only the effects of several ratios on the "predictiveness" of his bankruptcy model, but to consider how those ratios affected each other's usefulness in the model. The model has also been used successful for other types of companies, except for financial institutions.

Altman started out with 22 ratios classified into five categories; liquidity, profitability, leverage, solvency and activity. Over the years since its introduction, the Z-Score has been improved and eventually narrowed down to five ratios. It has become one among the reliable predictors of bankruptcy and many analysts nowadays use this method above any other because of its wide applications. In fact, once Altman re-evaluated his strategies by examining eighty-six distressed firms from 1969 to 1975 and then 110 bankrupt firms from 1976 to 1995 and later 120 bankrupt firms from 1996 to 1999. The Z-Score had an accuracy level of between 82% to 94%, which was more than that achieved by any of the methodologies that existed.

These five ratios are as below

X1 = (Net Working Capital / Total Assets).

X2 = (Retained Earnings / Total Assets).

X3 = (EBIT / Total Assets).

X4 = (Market Value of Equity / Total Liabilities).

X5 = (Sales / Total Assets).

The multivariate equation used is,

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5.

The relevancy and predictability of the metrics used above are also intuitive, but I will not elaborate here. Here, we will just make use of the formula to evaluate one of my favorite stocks, Eversendai, just for illustration.

Z-score of Eversendai

From the latest annual report for year ended 31st December 2018, here are the information extracted.

Figures in thousands

Working capital

586068

Total assets

3276136

Retained earnings

206618

EBIT

123530

Market cap

323700

Book value of total liabilities

2305938

Sales

1705750

Price on 5th June 2019

0.415

No. of shares

780000

The computation of Altman Z-score is as followed,

X1 = Working Capital / Total Assets

0.17889

X2 = Retained Earnings / Total Assets

0.06307

X3 = Earnings before Interest and Taxes / Total Assets

0.03771

X4 = Market Value Equity / Book Value of Total Liabilities

0.14038

X5 = Sales / Total Assets

0.52066

Z

1.03228

The Interpretation of Altman Z-Score:

According to the interpretation of the Z-score from Altman’s multivariate analysis,

Z-SCORE greater than 3.0 –The Company is considered ‘Safe’ and has a negligible chance of getting to bankruptcy.

Z-SCORE between 2.99 and 1.23 – ‘On Alert’. This is in the “grey zone” area with moderate chance of bankruptcy and one should ‘Exercise Caution’.

Z-SCORE below 1.23- In “distress zone” area. Probability of Financial Catastrophe is Very High.

I hope you would be able to interpret the risk of investing in Eversendai based on this analysis.

The success in investing is not from constantly having multi-baggers in your stock investment, as investing is not that simple, and if it is so simple, everybody dabbling in the stock market will be filthy rich now, but to the contrary. On the other hand, if you can avoid losing big in potential bankrupt companies, you will do better than most players in the stock market. That is for sure. Start using this check if you are unsure if a stock tip you hear is worth investing.



kcchongnz Posted by (US/CHN trade war doesn't matter) Philip > Jun 5, 2019 7:18 AM | Report Abuse
The fine tuning of ratios were based on taking a group of US companies performance 40 years ago to define what is risk. It is very difficult to apply to a group of US companies in 2000, much less comparing Bursa companies in 2019. The definitions are very very different here from my experience.

That is true. Unless someone here has done some recent research in Malaysia and come out with our multivariate regression model from local companies which had bankrupted, the model can only be used as a guide at best. But again, we may not really have long enough history and adequate sample size to do so.

But if we look at the metrics used; it is still an intuitive method to be used as an additional wedge in our golf bag.

The z-score punishes companies with high leverage. If a company has less net working capital in relation to total asset (X1), it is at risk of bankruptcy as it will not be able to fulfil its short-term payment obligation if forced to (some limitations here as some good companies need little or no working capital). If a company has little retained earnings (X2), it has to fund its growth with excessive debts which makes it risky. If its return on assets (X3) is low, it is not good as earnings may not be enough to pay debts. If the market value of the company is low in relation to its total liabilities, and hence debts (X4), further deterioration endangers its survival. If the asset turnover (X5) is low, how is the company going to make decent return justifying the assets and hence the debts it uses?

So Z-score can be a good guide for the general public to avoid investing in stock tips and rumours. Sendai is one of the best example in i3investor.

I hardly use Z-score, except for teaching purpose, as I never buy risky companies with precarious balance sheet and poor return on assets. Neither do you need to, unless of course if you think about shorting companies, but shorting itself is a risky endeavour.
05/06/2019 9:37 AM

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