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Is your favourite company manipulating its numbers?

Oct 6, 2015

In this issue:
» QIP investors see big losses on recent investments
» RBI rate cut spurs mini rally of sorts
» ...and more!

00:00

I recently wrote two articles for the premium edition of the 5-Minute Wrap Up

The discussion revolved around earnings multiples and how much investors should be willing to pay for companies with different dynamics - mainly earnings quality and growth.

These were the key takeaways:

  • Growth plays a strong role in influencing company valuations.
  • If a company earns returns above its cost of capital, its value would only rise as and when growth rates pick up.
  • If a company's return ratio is at par with its cost of capital, no amount of growth or de-growth would change the multiple it deserves.
  • If a company earns returns below its cost of capital, more value would be destroyed as growth rates rise.
Given that growth plays a strong role in determining valuations, company promoters and managements are often tempted to up their business' value by taking shortcuts. Not to mention the pressures of keeping their strong performance intact after the market identifies the company as the next 'hot stock'.

Such shortcuts include number manipulation.

While it may be quite difficult to pinpoint genuine manipulation cases, investors can use a bunch of tools to raise red flags. We came across an exciting tool called the Beneish M-score.

The M-score was created by Indiana University professor Messod D Beneish. The model earned widespread recognition after a group of MBA students posted warnings about Enron's earnings manipulation a year before the incident. Adding to the tool's credibility is its high accuracy (as much as 71%) rate of detecting high profile accounting fraud cases well in advance.

So, how is it calculated? We will take the help of an explanation by valuesignals.com to take this further:

    The M-Score is based on 8 variables, of which some are designed to capture the effects of manipulation while others show preconditions that may prompt firms to engage in such activity. While Beneish takes data from the fiscal years, we use the last trailing twelve month (TTM) numbers available as current year, year t. For year t-1 we take the TTM results for the 12-month period before year t.
  • Days Sales in Receivables Index (DSRI): The ratio in days sales in receivables during the last year (t) compared to the year before (t-1). A disproportionate increase in receivables relative to sales may be suggestive of revenue inflation.

  • Gross Margin Index (GMI): GM in year t-1 / year t. If A value greater than 1 indicates that margins have deteriorated and this signals a negative signal about firms' prospects.

  • Asset Quality Index (AQI): Asset Quality in year t / year t-1. Asset Quality is the ratio of non-current assets other than plan, property and equipment as a proportion of total assets. An AQI greater than 1 indicates that a firm has potentially increased its involvement in cost deferral.

  • Sales Growth Index (SGI): Sales in year t / year t-1. Growth does not imply manipulation, but growth firms are more likely to commit fraud because their financial position and capital needs put pressure on managers to achieve earnings targets. In addition, controls and reporting tend to lag behind operations in periods of high growth. Any perception of decelerating growth can have a significant impact on the value of the stock and be very costly to management. A value greater than 1 increases the probability of earnings manipulation.

  • Depreciation Index (DEPI): The rate of depreciation in year t-1 / year t. The rate of depreciation is equal to depreciation / (depreciation + net property, plant & equipment). If this value is greater than 1 this means that the rate at which assets are depreciated has slowed down. Either management revised upwards the estimates of assets useful lives or adopted a new method that is income increasing.

  • Sales General and Administrative Expenses Index (SGAI): The ratio of SGA to sales in year t / year t-1. Analysts would interpret a disproportionate increase in sales as a negative signal about firms' future prospects. Beneish expects a positive relation between SGAI and the probability of manipulation.

  • Leverage Index (LVGI): The ratio of total debt to total assets in year t relative to year t-1. A value greater than 1 indicates an increase in leverage.

  • Total Accruals to Total Assets (TATA): Total accruals is calculated as the change in working capital accounts other than cash less depreciation. This ratio proxies the extent to which cash underlies reported earnings. Higher positive accruals (less cash) indicates a higher likelihood of earnings manipulation.
Now, to calculate the M-score, the eight variables are then provided weights according to the following formula:
    M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI - 0.172*SGAI + 4.679*TATA - 0.327*LVGI
As per the website, a score greater than -1.78 indicates a strong likelihood of earnings manipulation.

What is also interesting is that stocks of companies that ranked poorly based on this tool underperformed. During the fourteen year period ending 2007, stocks that were flagged as earning manipulators returned 9.7% less than the companies that were not identified as such.

The M-score is one of the few tools to determine companies poised for bankruptcy and financial fraud. Other well known tools include the Altman Z-score and the C-score.

In fact, very recently, we released a "Crash Score" report. Not only has this tool been able to identify companies with deteriorating financials, but this process has also helped to identify 'poisonous stocks' - elimination of which could provide a strong boost to your portfolio.

We have made the report available FREE to all. Do make sure you grab a copy today.

Have you made attempts to identify companies that could possibly be manipulating their books? What tools did you rely on? Let us know your comments or share your views in the Equitymaster Club.

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02:50
 Chart of the day
Talking about losses, one would think that qualified institutional investors would surely have the wherewithal to avoid big losses in the stock market. Thus when they make investments in companies through Qualified Institutional Placements (QIPs), many even take it as a positive cue for the company involved. However, the real picture seems to be a little different.

A recent report in the Economic Times points out the sorry fact that more than 60% of such investors who invested in companies through QIPs since 2014 are currently sitting on losses. Evidently, like many a naive investor, they seem to have gotten swept away by the post general election enthusiasm. And in the process, have ended up paying exuberant prices for many companies who raised capital during this time. In fact, the report goes on to observe that 35 of the 57 companies that have raised capital since then are currently trading below the offer price.

Yes, one to two years is not a very long period to judge performance. But as today’s Chart of the Day shows, many of these stocks are down by a such a significant margin from their offer price that one feels compelled to question the rationality of the prices at which such investments were made!

QIP Investors see Big Losses as Reality Sinks In


03:55
Stock market investors have been a delighted lot over the last week or so since the Reserve Bank of India’s (RBI) rate cut last Tuesday. As an article in the Mint points out, the BSE Sensex has gained a hefty 1,169 points (4.56%) since the rate cut. In fact, the BSE Sensex and the NSE Nifty have reportedly gained on each of the five trading days since the policy announcement. In the process, they’ve taken these indices to their highest level in almost 45 days.

It is precisely at times such as these that investors need to remember that such short term boosts to sentiment and the resultant buoyancy in stock prices can prove to be highly temporary. It often takes just a whiff of the next bad news for the stock market to completely forget any good news that came before it. Further, the real impact of the rate cut on the ground realities of the sluggish economy too remain to be seen. Monetary policy action does not always yield the desired result. So be sure to not give such events more importance then they deserve.

04:40
Though they began on a strong note, the Indian stock markets were trading flat towards noon. At the time of writing, the BSE-Sensex was trading up by around 25 points. Gains were largely seen in pharma and consumer durables stocks.

04:50
 Today's investing mantra
"Often, there is no correlation between the success of a company's operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies." - Peter Lynch

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst).

Today's Premium Edition.

Time to Invest in PSU Banks?

Stock prices of PSU banks have taken a beating while private banks have done much better.
Read On...Get Access

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Equitymaster requests your view! Post a comment on "Is your favourite company manipulating its numbers?". Click here!

2 Responses to "Is your favourite company manipulating its numbers?"

Ravi shah

Oct 7, 2015

Dear EQM,
Being a subscriber We expect from you that pl recommend stocks only having good margin of safety and applying all possible M-SCORE,8 variables, in short all possible steps to curb losing of our capital.You are known for unbaised and honest recommendation.Thnks

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Rajagopalan Ramesh

Oct 6, 2015

The 5-minute wrap-up premium has really become an Education to all serious investors and it is certainly useful. The M-Score and C-Score capture many pitfalls by application of certain ratios. A careful analysis of all Assets / Profitability / Net-worth ratios will bring out anomalies in financial reporting. I give a lot of importance to study of Cash Flow Statements - especially the cash-flows from operations. In addition to this, the Notes to Accounts will reveal hidden manipulations - for example, a change in method of accounting; reporting of contingent liabilities; direct and indirect tax dues and their treatment in books of accounts; legal cases due to which certain provisions or liabilities are not accounted etc., But investors who cannot spend considerable time in reading Annual Reports, can very much rely on M-Score or C-Score for taking right decisions about a particular stock.
Keep writing such useful articles. Thanks to the team.

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Equitymaster requests your view! Post a comment on "Is your favourite company manipulating its numbers?". Click here!
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  1. Buy recommendation: This means that the investor could consider buying the concerned stock at current market price keeping in mind the tenure and objective of the recommendation service.
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