Altman Z: The Long Lost Safety Statistic
There have been many bankruptcies during 2020, as the COVID-19 pandemic weakened companies including J. Crew, Hertz, 24 Hour Fitness, JCPenney, and dozens of others. These examples show how safety in investments is instrumental. In order to grow your money over a long period of time the companies where your money is placed must be financially sound. There are multiple statistics that attempt to predict the potential earning of a company, however, there are only a few that can confidently supply a prediction of safety and sustainability of a given business.
One of the most useful statistics to measure safety is the Altman Z score, a composite number that combines liabilities, assets, earnings, and market value. These are the building blocks for most industrial businesses and give you a good idea of the risk of the business based on its profitability and the scale at which it works. The Altman Z score creates ratios that compare and contrast the multitude of statistics that show the earnings in different lights, as well as factors in the market value in order, round out the view of the company to add a view of safety to the traditional views of profitability, growth, and value.
Between all of these evaluations, the Altman Z safety is measured by a score usually ranging from 0 to 10. The score indicates if a company may be in financial peril within the next two years. The scores are separated into three “zones”. The first area in the “Safe Zone” are companies that have scores of 3 or higher indicating a safe investment. The “Safe Zone” is the best place to have your investments. The second zone is the “Danger Zone” which contains businesses with scores of 1.8 or less. These companies have increased risk of financial trouble within the next two years. Because of this time frame companies listed in the “Danger Zone,” most of the time are inadequate long term investments. The final zone consists of businesses with scores from 1.8 to 3 this is the “Gray Area”.
Here are some recent examples of companies Altman Z Scores:
Boeing: 1.7 (“Danger Zone”) - Boeing’s Altman Z score has dropped through this recent financial turmoil as they typically do and is now in the “Danger Zone”
Lockheed Martin: 3.9 (“Safe Zone”)- Lockheed has an Altman Z score has also dropped however despite being in the same field as Boeing they are a strong standing member of the “Safe Zone”
The scores try to predict the financial health of a company in the future, but they are of course based on the past. You can see the troubles that Boeing has had recently reflected in its low score, however at the end of 2018 Boeing had a score of 3.0. Scores are moving targets and they are a good starting point for analysis, but not the end.
One of the most useful statistics to measure safety is the Altman Z score, a composite number that combines liabilities, assets, earnings, and market value. These are the building blocks for most industrial businesses and give you a good idea of the risk of the business based on its profitability and the scale at which it works. The Altman Z score creates ratios that compare and contrast the multitude of statistics that show the earnings in different lights, as well as factors in the market value in order, round out the view of the company to add a view of safety to the traditional views of profitability, growth, and value.
Between all of these evaluations, the Altman Z safety is measured by a score usually ranging from 0 to 10. The score indicates if a company may be in financial peril within the next two years. The scores are separated into three “zones”. The first area in the “Safe Zone” are companies that have scores of 3 or higher indicating a safe investment. The “Safe Zone” is the best place to have your investments. The second zone is the “Danger Zone” which contains businesses with scores of 1.8 or less. These companies have increased risk of financial trouble within the next two years. Because of this time frame companies listed in the “Danger Zone,” most of the time are inadequate long term investments. The final zone consists of businesses with scores from 1.8 to 3 this is the “Gray Area”.
Here are some recent examples of companies Altman Z Scores:
Boeing: 1.7 (“Danger Zone”) - Boeing’s Altman Z score has dropped through this recent financial turmoil as they typically do and is now in the “Danger Zone”
Lockheed Martin: 3.9 (“Safe Zone”)- Lockheed has an Altman Z score has also dropped however despite being in the same field as Boeing they are a strong standing member of the “Safe Zone”
The scores try to predict the financial health of a company in the future, but they are of course based on the past. You can see the troubles that Boeing has had recently reflected in its low score, however at the end of 2018 Boeing had a score of 3.0. Scores are moving targets and they are a good starting point for analysis, but not the end.
There is a saying that says that you grow your wealth on the income statement, but you survive on the balance sheet. The Altman Z score is a survival score. The balance sheet encapsulates almost every statistic needed to calculate an Altman Z score. The ratios from these numbers are as follows:
X1 is the Working Capital divided by the Total Assets
X2 is Retained Earnings divided by the Total Assets
X3 is the Earnings Before Interest and Taxes divided by the Total Assets
X4 is the Market Value of the business divided by the Total Liabilities
X5 is Net Sales divided by the Total Assets
The formula is:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5
Although, the Altman Z score is a well-respected method to predict risk in companies there are some critique. Most notably the fact that Market Value is listed/factored into the equation. Many investors believe for a good reason that it should not contain this because it doesn’t properly portray safety. An example of this is Tesla(TSLA) which whether you are a fan or not is an extremely risky company, however, at the time of writing it has a quarterly Altman Z score of 3.2 which is in the “Safe Zone” and Tesla is the kind of company this statistic is built for. Tesla's high flying stock price may make the company seem safer than perhaps it is.
Safety and The Long Run
The Altman Z score is an essential number that can be extremely influential and important to investors' success. If you can find companies with good return statistics and an Altman Z score in the “Safe Zone” then you have a great setup for solid returns over an extended period of time.
The Altman Z Score is helpful for analyzing safety in a long term investing approach, such as the Coffee Can method. The Coffee Can Method is an investing idea where you invest your money and proceed to basically forget about your money as it compounds until your retirement. This method of investing is supported by a study at Fidelity where researchers found that the portfolios that housed the best returns were the ones where the account holder forgot they had the account. That study shows you how much potential this style of investing has, however, the key to the success of the strategy is safety which can be most easily and reliably found in you guessed it the Altman Z score.
X1 is the Working Capital divided by the Total Assets
X2 is Retained Earnings divided by the Total Assets
X3 is the Earnings Before Interest and Taxes divided by the Total Assets
X4 is the Market Value of the business divided by the Total Liabilities
X5 is Net Sales divided by the Total Assets
The formula is:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5
Although, the Altman Z score is a well-respected method to predict risk in companies there are some critique. Most notably the fact that Market Value is listed/factored into the equation. Many investors believe for a good reason that it should not contain this because it doesn’t properly portray safety. An example of this is Tesla(TSLA) which whether you are a fan or not is an extremely risky company, however, at the time of writing it has a quarterly Altman Z score of 3.2 which is in the “Safe Zone” and Tesla is the kind of company this statistic is built for. Tesla's high flying stock price may make the company seem safer than perhaps it is.
Safety and The Long Run
The Altman Z score is an essential number that can be extremely influential and important to investors' success. If you can find companies with good return statistics and an Altman Z score in the “Safe Zone” then you have a great setup for solid returns over an extended period of time.
The Altman Z Score is helpful for analyzing safety in a long term investing approach, such as the Coffee Can method. The Coffee Can Method is an investing idea where you invest your money and proceed to basically forget about your money as it compounds until your retirement. This method of investing is supported by a study at Fidelity where researchers found that the portfolios that housed the best returns were the ones where the account holder forgot they had the account. That study shows you how much potential this style of investing has, however, the key to the success of the strategy is safety which can be most easily and reliably found in you guessed it the Altman Z score.
The final and in my opinion, one of the most important features of the Altman Z score is that you are making a more informed investment. The increase in knowledge can in turn reward investors with larger and more consistent returns and more notably this should limit losses which altogether is a recipe for more profitable investing.
The Altman Z score is extremely helpful and can save investors from investing in faulty businesses. However it does not work everywhere, the Altman Z score was established to analyze the safety of industrial businesses. Therefore, it does not accommodate businesses like banks, insurance, or internet companies. This is because they do not have a product in the conventional sense, for example, most internet companies sell advertising space on their platforms. Internet businesses don’t usually have very many viable assets, however, they contain value that can’t be seen on the surface which accounts for a significant amount of their importance. These are things that aren’t physical assets but given the business a moat. These include things like the brand(people can be very brand loyal when it comes to social media because it feels safer from the familiarity of it) and social connection. These “assets” are part of the reason some internet businesses are safer than they appear and can’t be given an accurate Altman Z score. This is true because of a few different features, however, the overarching ideas aren’t all that different to explain why the Altman Z score doesn’t work for insurance companies and banks.
The Altman Z score serves multiple interlocked purposes which are all based around the safety of an investment. It analyzes the sustainability and risk of a business to ensure more prosperous investing periods.
If you don’t want to calculate the score yourself then the Altman Z score can be found on koyfin.com in the Financial Analysis section.
*I am not a financial professional and I am not responsible for your investing successes or failures
always do your own research.
Twitter - @soreninvesting
Investing Videos - https://www.youtube.com/channel/UCjHhTKFS0Ub8r26Yw6ZCfcA/featured
The Altman Z score is extremely helpful and can save investors from investing in faulty businesses. However it does not work everywhere, the Altman Z score was established to analyze the safety of industrial businesses. Therefore, it does not accommodate businesses like banks, insurance, or internet companies. This is because they do not have a product in the conventional sense, for example, most internet companies sell advertising space on their platforms. Internet businesses don’t usually have very many viable assets, however, they contain value that can’t be seen on the surface which accounts for a significant amount of their importance. These are things that aren’t physical assets but given the business a moat. These include things like the brand(people can be very brand loyal when it comes to social media because it feels safer from the familiarity of it) and social connection. These “assets” are part of the reason some internet businesses are safer than they appear and can’t be given an accurate Altman Z score. This is true because of a few different features, however, the overarching ideas aren’t all that different to explain why the Altman Z score doesn’t work for insurance companies and banks.
The Altman Z score serves multiple interlocked purposes which are all based around the safety of an investment. It analyzes the sustainability and risk of a business to ensure more prosperous investing periods.
If you don’t want to calculate the score yourself then the Altman Z score can be found on koyfin.com in the Financial Analysis section.
*I am not a financial professional and I am not responsible for your investing successes or failures
always do your own research.
Twitter - @soreninvesting
Investing Videos - https://www.youtube.com/channel/UCjHhTKFS0Ub8r26Yw6ZCfcA/featured
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