If you’re a short seller, then I’d like to introduce you to the Ohlson O-Score. This is a score created by Dr. James Ohlson of New York University, aimed at predicting the financial distress of a company. The Ohlson O-Score is the result of a nine-factor linear combination of coefficient-weighted accounting ratios that are found from financial disclosure statements that are provided by publicly traded companies. Below is the actual formula for the Ohlson O- Score.
So, from a first glance it looks very complex. Well, that’s because it is. For the purpose of understanding what exactly this equation is composed of, let’s break it down piece by piece. Below the equation is presented again with the variables defined. Two of the factors of the equation are generally considered useless since their value upon the formula is typically zero.
TA = Total assets CA= Current Assets
GNP= Gross National Product Index level X= 1 if TL > TA, (otherwise it’s 0)
TL= Total Liabilities NI= Net Income
WC = Working Capital FFO= Funds from Operations
CL= Current Liabilities
Y= 1 if a net loss for the last two years,(otherwise it’s 0)
But just how accurate is the Ohlson O-Score? Any company that results with a score greater than .5 indicates a company has a high chance of bankruptcy. Let’s back test the Ohlson O-Score and see how accurate it has been in recent times. Below you can see the heat map and back tested chart of the Ohlson O-Score from the last 2 years. +
Heat Map of the Ohlson Score > 10
As you can clearly see, the Ohlson O-Score is very accurate for determining failures in various companies. Let’s see what kind of difference we get when we increase the score result from >.5 all the way to >10.
From the heat map, you can especially see that biotech companies are commonly under financial stress for reasons I discussed in a previous article pertaining to the biotech industry specifically. It is also important to note that some of these companies did not fail, and instead ended up having tremendous returns such as Loxo Oncology which ended up having a 394.12% return in just two years’ time. This shows that the Ohlson O-Score cannot account for various economic and industry specific factors. Nevertheless, the Ohlson O-score can still be a very helpful indicator when looking at a company’s financial distress.
In conclusion, the Ohlson O-Score screener can definitely help you either find companies to short sell or find companies to avoid. As I said earlier, the Ohlson O-Score cannot account for various economic conditions and industry specific factors. If you think you can do better than the Ohlson O-Score or even improve on it, then build your own score. Equities Lab offers you an immense amount of data spanning all the way back to 1995 so take advantage of that to build the perfect score.