The Altman Z-Score is a formula of 5 basic financial ratios to help determine the financial health of a company. In particular, it is a probabilistic model to screen for bankruptcy risk of a company.
As value investors, one of our most important rules is to avoid incurring large losses. There are two easy ways to subject yourself to possible large losses; buy stocks for more than they’re worth, and buy stocks of companies that go bankrupt.
If you buy an asset with an intrinsic value of $100 for $60; you have a large margin of safety. It is highly unlikely you will lose a lot of money on this purchase, unless, the company goes bankrupt. Sure it might fall to $50, or even $40, but it will most likely not approach zero unless the company is headed for bankruptcy.
I learned this lesson the hard way in 2000 when I bought Enron. No, I didn’t pay $80, or $60, or $30, or even $10. I was a value investor! I waited until it got down to $5! But does it really matter? I still lost 100% of my money on that investment. If I had used the Altman Z-Score, which was warning of an impending bankruptcy, I would have avoided a total loss.
The Altman Z-Score Formula
The original formula was created for publicly traded manufacturing companies.
Z-Score = 1.2(A) + 1.4(B) + 3.3(C) + 0.6(D) + 1.0(E)
Where:
A = Working Capital (Current Assets – Current Assets) / Total Assets (Measures liquidity of firm)
B= Retained Earnings / Total Assets (measures accumulated profits compared to assets)
C= Earnings Before Interest & Taxes (EBIT) / Total Assets (measures how much profit the firms assets are producing)
D= Market Value of Equity (Mkt. Cap. + Preferred Stock) / Total Liabilities (compares the company’s value versus it’s liabilities)
E= Sales / Total Assets (efficiency ratio – measures how much the company’s assets are producing in sales).
Z-Score Results:
Z-Score of < 1.81 represents a company in distress.
Z-Score between 1.81 and 2.99 represents the “caution” zone.
Z-Score of over 3.0 represents a company with a safe balance sheet.
The Altman Z-Score has become popular enough to be found in most data services such as Y-Charts.
Here is a Z-Score calculator for those who want to figure the calculation directly from company financials:
History of the Altman Z-Score
Edward Altman was a NYU Stern Finance Professor in 1968 when he developed the original Z-Score. Recently, he has produced updated versions for private companies, non-manufacturing companies, and emerging markets companies (see below).
For those interested in really delving into the subject, here is his 2000 Research Paper:
Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta Models
The Altman Z-Score Formula
The original formula was created for publicly traded manufacturing companies.
Z-Score = 1.2(A) + 1.4(B) + 3.3(C) + 0.6(D) + 1.0(E)
Where:
A = Working Capital (Current Assets – Current Assets) / Total Assets (Measures liquidity of firm)
B= Retained Earnings / Total Assets (measures accumulated profits compared to assets)
C= Earnings Before Interest & Taxes (EBIT) / Total Assets (measures how much profit the firms assets are producing)
D= Market Value of Equity (Mkt. Cap. + Preferred Stock) / Total Liabilities (compares the company’s value versus it’s liabilities)