How to Score Compound Income↑ Stocks Part 3 - P&IC Cover

In this section we are going to be looking at ways of assessing the finances of Companies. For this I use two main measures, the first one is more complicated and is called the Piotroski F score, named after the professor who devised it. The second is more simple - interest cover, the number of times interest payable is covered by operating profits see highlighted link for more details.

The Piotroski F Score comes from an academic paper in which he aimed to use historic financial data to separate winners and losers in value portfolios. This looks at profitability, leverage, liquidity and sources of funds and operating efficiency as explained in brief here. Thus it seems a suitable metric to use as I am using a value based screen when trying to identify Compound Income stocks. In addition since the research was most effective in small and medium sized firms and those with low share turnover and no analyst coverage it is helpful as my portfolio is biased in that direction generally. It may also be helpful in providing reassurance or a warning on small unknown stocks that might score well or badly on this measure. It also touches on other aspects of the business operations, apart from just the financing, which is also useful. The other way in which the Piotroski score can be used is in conjunction with valuation based models as a filter for selecting the best stocks (those scoring 8 to 9) or excluding the most vulnerable stocks (those scoring 2 or less).

You can read the original research by clicking the highlighted link above. Others have also found that by using this measure with other valuation metrics that they can improve their performance. It is generally used to identify the stronger and weaker companies. By combining this with interest cover and scoring it accordingly I can get a quick handle on the financial strength or weakness of a company. This can then act as a green or red flag for further investigation and confirmation when doing further research.

In addition it is worth pointing out that interest cover may flatter some stocks like retailers or other companies who have lots of leased premises or equipment. Then you will need to look at fixed charge coverage to get a better feel for their financial viability going forward, but in any event it always worth doing more research whatever a particular indicator says. It is also worth noting that interest cover is not that instructive with financial companies either so you will need to asses them on their own merits and understand the nature of the business, although in some cases they may not have any debt.

Other than that you can of course use more traditional measures of gearing such as debt to equity where you should normally be wary of anything over 50% depending on the nature of the business. You could also consider the debt to Enterprise Value to see what proportion of the financing is coming from debt, as debt to a certain extent can be beneficial for shareholders, but it does increase the risks. Debt to EBITDA multiples are also often used in debt covenants and sometimes companies may disclose this figure as a way of showing how much headroom they have.