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Accruals: Not All Earnings Are Made The Same, And How To Spot The Difference

To most investors, earnings is a magic word, one that rings a special little bell in their minds during earnings season, one line on the I/S that can swing the price of a stock like a pendulum. It also makes up 50% of the most commonly used and recognized ratio, the P/E ratio. The ability to manipulate the earnings of a company is one of the easiest compared to cash flow or sales. With managers discretion (hopefully unbiased estimation) on unearned revenue, deferred expense, accrued revenue, and accrued expense we see how manipulation can happen. Add pressure to meet or exceed analyst estimates, we can see why some managers would be willing to fudge the numbers.

There needs to be a method for the average investor to quickly cut through the data to get a sense of the quality of the earnings. Luckily for the average investor there are a few not so well knows industry methods to do just this. The Accrual ratio developed by Professor Richard Sloan from the University of Michigan in 1996 is what we are going to use.

Some Quick facts

Earnings are made up of a lot of non-cash earnings, which are referred to as accruals.

Trying to pick winning stocks from analyzing the I/S, B/S and CF/S is not a new thing.

Back in 1996, Richard Sloan, a former University of Michigan researcher, screened the performance of stocks based on their earnings quality, or better yet accrual ratio's.

The companies with lower accrual ratios outperform companies with higher accrual ratios.

"Over a 40-year period between 1962 and 2001, buying the lowest accrual companies and shorting the highest accrual companies resulted in an average annual compounded return of 18% compared to the S&P 500's 7.4% annual return over the same period." Source: by Jim Fink on June 18, 2012.

Keep in mind that Professors Sloan's numbers are based on averages. Not every stock will perform as predicted by the ratio.

Let's get started

1. The quicker method.

Where NI= net income, CFO=cash from operation and CFI= cash flow from Investing. We are using Total assets as a quick approximation for NOA or net operating assets

2. Accruals based on NOA

AccuralsBS=NOAt - NOA t-1

AccuralsCF = NI - CFO - CFI

The other message from Sloan's research is more surprising. Even though accruals provide valuable information about stock prices, few people pay attention. That's why Sloan's strategy racks up those large returns, his analysis identifies winners and losers before others catch on. Sloan thinks this is because investors focus too closely on earnings and ignore valuable information in other accounting data. But it might just be that they're lazy

"The extremes are where Sloan's strategy kicks in. Anything above 5%

is a sell; below -5% is a buy."

Source: by Jim Fink

So whether your looking for a lowest accruals ratio in a favorable industry, or you add this to your screen of a variety of different companies. This is another powerful tool at your disposal.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.