Applied Finance Group's Earnings Quality variable is a proven indicator of companies that are more likely to have negative earnings surprises, and therefore underperform due to high amounts of accruals (difference in net income vs. cash flow). Corporations are constantly under pressure to meet sales expectations, so it is very important to watch out for those companies that may be trying to pad their sales numbers in various ways, i.e. channel-stuffing (sending excess inventory to stores that will not be able to sell their products).
Because high EQ score companies (bad Earnings Quality) are more likely to have negative earnings surprises, you will probably want to avoid these firms. Our back-tests indicate that the EQ variable works especially well when coupled with AFG’s valuation model (see charts below). The first chart highlights the performance of companies when you separate the top half (best earnings quality companies) from the bottom half (worst earnings quality companies) across all sector size and style categories.
[Click all to enlarge]
The next chart illustrates the value added to your stock selection process when you combine AFG Earnings Quality score with valuation. The red and green bars represent the performance of the top half / most attractive valuation companies and the red bars represent the bottom half / unattractive firms. The red and green dots represent the value-added performance when you add EQ to the equation.
Firms in the top half of valuation attractiveness and top half of EQ tend to outperform more often than not, while the opposite is true for firms that land in the bottom half of both categories in most sectors, sizes and styles. (Note: Financial companies are not included in any EQ analysis, as a good portion of their business is accrual-based.)
We have put this variable to work for you, screening the S&P500 to identify the firms with the worst Earnings Quality score that also rank poorly according to AFG’s default valuation ranking (bottom half of valuation rank).
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Earnings Quality Score Insights:
Accruals
• An accrual is the difference between Cash Flow and Net Income.
• Net Income = Cash Flow + Accruals
• Low Accrual companies outperform high accrual companies
Two ways to approach accruals:
1. Cash Flow Statement
• Difference between Net Income and Cash Flow
2. Balance Sheet
• Change in Net Operating Assets from Period t-1 to t
• Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)
Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach. We found the Balance Sheet approach is also easier to expand to international companies.
