Altman and Z score - Successful short term portfolio strategy?

Discussion in 'Strategy Building' started by senthil196, Aug 24, 2007.

  1. Quick history:
    "The Z-Score bankruptcy predictor combines five common business ratios, using a weighting system calculated by Altman to determine the likelihood of a company going bankrupt. It was derived based on data from manufacturing firms, but has since proven to be effective as well (with some modifications) in determining the risk a service firm will go bankrupt."

    The original equation with modifications is Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + .6*X4 + X5

    X1 - EBIT/Total Assets
    X2 - Net Sales /Total Assets
    X3 -Market Value of Equity / Total Liabilities
    X4 - Working Capital/Total Assets
    X5 -Retained Earnings /Total Assets

    In his original dissertation Dr. Altman says "The potential of applying the suggested MDA model for hedge type investing or for normal short sales is certainly present and possible rewards are intriguing."

    What surprises me is that I have found virtually no one in wall street using the model, although z score is popular in loan evaluation ranging from "auditors, management consultants, and courts of law."

    Although it has been about 40 years since original publication, I believe the data is still relevant today, however the equation is not. While I have not done any research, I doubt the Z score (derived from the original equation) would amount to a successful short position.

    But, if we were to use Multiple Discriminant analysis for individual sectors/industries and arrive at z score equation that is relevant to the data from the respective companies that have gone bankrupt, I think it would amount to a successful short strategy.

    Any comments?

  2. Whether this is a route to a successful investment strategy, I cannot say. However, estimation of the probability of the bankruptcy of firms (and individuals) is done using a variety of techniques (logistic regression, neural networks, etc.).