The Beneish M-Score: Identifying Earnings Management and Short Candidates
In Brief
Created by Professor Messod Beneish, the M-Score is a mathematical model that uses eight financial ratios to identify whether a company has managed / manipulated its earnings. The variables are constructed from the company's financial statements and create a score to describe the degree to which the earnings have been manipulated. In many ways it is similar to the Altman Z-Score, but it is focused on detecting earnings manipulation rather than bankruptcy.
Interestingly, students from Cornell University using the M score correctly identified Enron as an earnings manipulator, while experienced financial analysts failed to do so.
Calculation / Definition of the M-Score
The M score is based on a combination of the following eight different indices:
- DSRI = Days’ Sales in Receivables Index. This measures the ratio of days’ sales in receivables versus prior year as an indicator of revenue inflation.
- GMI = Gross Margin Index. This is measured as the ratio of gross margin versus prior year. A firm with poorer prospects is more likely to manipulate earnings.
- AQI = Asset Quality Index. Asset quality is measured as the ratio of non-current assets other than plant, property and equipment to total assets, versus prior year.
- SGI = Sales Growth Index. This measures the ratio of sales versus prior year. While sales growth is not itself a measure of manipulation, the evidence suggests that growth companies are likely to find themselves under pressure to manipulate in order to keep up appearances.
- DEPI = Depreciation Index. This is measured as the ratio of the rate of depreciation versus prior year. A slower rate of depreciation may mean that the firm is revising useful asset life assumptions upwards, or adopting a new method that is income friendly.
- SGAI = Sales, General and Administrative expenses Index. This measures the ratio of SGA expenses to the prior year. This is used on the assumpton that analysts would interpret a disproportionate increase in sales as a negative signal about firms future prospects
- LVGI = Leverage Index. This measures the ratio of total debt to total assets versus prior year. It is intended to capture debt covenants incentives for earnings manipulation.
- TATA - Total Accruals to Total Assets. This assesses the extent to which managers make discretionary accounting choices to alter earnings. Total accruals are calculated as the change in working capital accounts other than cash less depreciation.
The eight variables are then weighted together 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
There is also a five variable version which excludes SGAI, DEPI and LVGI (as these were not significant in the original Beneish model).
- M = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEP
The exact threshold varies depending on the probabilty of of mis-classification but, broadly speaking, a score greater than -1.78 (i.e. less negative or positive number) indicates a strong likelihood of a firm being a manipulator.
Does the Beneish M-Score work?
Beneish used all the companies in the Compustat database between 1982-1992. In his out of sample tests, Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of non-manipulators.
In a 2007 paper - The Predictable Cost of Earnings Manipulation - Beneish examines the use of the M score as a stock selection technique (over the period 1993-2003). The M-score strategy apparently generated a hedged return of nearly 14% per annum. A subsequent paper titled "Identifying Overvalued Equity" showed that an overvaluation score (O-Score) combining proxies for earnings overstatement, merger activity, stock issuance, and the manipulation of operating activities was able to identify firms with forecast abnormal price declines averaging -27%.
How can I run this Screen?
On Stockopedia Premium, of course! Sign up now for access to our exclusive Beta! There's an interesting thread on the interpretation of the M-Score here.
The Source:
This is the link to the original paper on the Detection of Earnings Manipulation - as well as to a subsequent paper by Beneish - The Relation between Accruals and the Probability of Earnings Manipulation.
Other Sources
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7 comments
Sig PLC and IQE add to the list?
A good indication of manipulation at Enron was second digit zeros in their revenue figures as they just bust psychological thresholds: ($m)
1997: 20,273
1998: 31,260
1999: 40,112
2000: 100,789
I can think of one UK quoted company, which looked an attractive investment, where I've seen similar.
Fishing Republic (LON:FISH) is identified by the screen and fell 40% today.
Thanks Mark.
To follow up on my point, people will undoubtedly remember Freddie Mac going down the tubes. I was aware that Buffett had a holding in one/both of them many years ago, and I wondered if he caught a cold on them. The answer is: he did not. Apparently he had sold out long before the trouble because he foresaw the problems that aggressive growth plan can lead to. http://wapo.st/lo3ELY
Warren Buffett likes to say he doesn't have more good ideas than other investors. He just has fewer bad ideas.
I think I still need to master that one.
Another Mark.
"Interestingly, students from Cornell University using the M score correctly identified Enron as an earnings manipulator, while experienced financial analysts failed to do so."
I think what's disappointing, though, is that they only concluded that Enron "may" be manipulating the earnings, and went on to say "However, further examination of these indicators showed no cause for concern.". They went on to produce a DCF valuation for Enron which showed it to be slightly overvalued. So basically, they didn't spot anything. It's a bit like performing a DCF valuation for the Titanic, noting that the lack lifeboats to accommodate all passengers is no cause for concern because it's unsinkable. I'm not saying that I could do any better, of course, but it shows that all the analyses by all parties concerned didn't really understand the company . If they had *really* understood the company, then they would have understood that it was doomed, and that no DCF would have made sense. It starts to make one wonder just how solid one's own understanding of companies really is. Perhaps that's why Buffett is such a great investor; he can see past all the "DCF" mumbo-jumbo into the heart of the matter.
Good article. please don't think that I am in any way knocking anybody.
Hi Mark,
Yup, absolutely correct. The trouble with DCF forecasts is that they're so senstive to assumptions about future unknown quantiites. If ones takes a purist Graham/Buffett POV then (almost*) all small natural resource companies are speculative because there is so much uncertainty about their value, depending on unknowable future pricing, costs and government taxation policies.
The purist approach looks for businesses with very solid foundations, that have been established for many years, produce consistent returns on a sustainable basis** and have a "moat" or USP that makes it hard for competitors to eat their lunch... and which you can acquire at an attractive price.
When attending the Ocean Wilsons (LON:OCN) AGM last week , I had the privilege of listening to and, after the meeting, chatting to William Salomon, who has a personal interest worth around £100m in the company (directly and via Hansa Trust (LON:HAN) ). There was an aggressive questioner attending, who tried to press the chairman for a figure on expected rates of return on private equity investments that Ocean Wilsons Investments holds. WS asked the Chairman if he could respond to that point and took the floor. He responded assertively that, as an investor of some considerable experience, the question was meaningless. Analyst forecasts one or two years ahead are not particularly accurate, so anyone that claimed they could forecast results 4-5 years ahead (necessary to compute an expected IRR) was a charlatan - and that's the sort of timeframe that PE investments are made on. They key is to choose good businesses.***
Having said all that, I have to hold my hands up not to being a "purist" investor myself and do hold a portion of more speculative investments in my portfolio. Nevertheless, the bulk of my portfolio is invested in businesses or investment companies that I consider soundly based for the long-term and attractively priced (like Ocean Wilsons itself!).
Mark
*One notable exception I call to mind was Encore Oil in late 2009, where investors were assured of a substantial cash return even in the event of failures of speculative activities with high upside potential undertaken by the company. At that time, I believe Encore was a genuine value investment.
**The importance of earnings sustainability was made very clear to investors, like myself, in apparently "good value" banks in 2007/8. I remain nervous of equity investment in companies like Aviva, whose earnings seem to me highly sensitive to financial market conditions.
***Ocean Wilson Investments (the investment portfolio, distinct from the Brazilian business) shows a creditable annualised return of around 8% since November 2000, consistently beating market indices. That's enough for me conclude that the portfolio is well managed.
Marben10 - I think the questioner may have had a point on Ocean Wilsons. Their investment portfolio hasn't done well in the last few years. They have gone for high cost and exotic funds. William Salomon should have had a benchmark rate that he wanted for private equity. The Ocean Wilsons investment fund has made a fair few mistakes such as Pershing Square. I don't think the answer from Salomon was a good one.... For me it comes across as slightly pompous... you wouldn't have Buffett answer a question like that...