How does balance sheet growth affect stock returns?

Last week, we have discussed in this column “How to beat the market with Sloan Ratios” that the stock market in general does not know how to distinguish between cash earnings and accrual earnings.

Because of this, investors often overestimate the accrual portion of a company’s earnings, which is of relative lower quality than the cash portion, resulting in a significant mispricing of stocks.

We introduced the use of the Sloan Ratio to measure the extent of accrual exposure of companies using net income and free cash flows, and found that the higher the Sloan Ratio of a Philippine Stock Exchange (PSE) index stock goes, the lower the stock will fall in three years.

In 2006, a team of researchers from the Wharton School of University of Pennsylvania led by Scott Richardson suggested that an alternative way to measure accrual ratios was the use of balance sheet data.

Richardson explained that accrued earnings were considered as growth in a company’s operating working capital, which formed part of its total assets.

Increases in accrued earnings such as rise in accounts receivables, capitalization of expenses or recognition of goodwill also increase total assets.

Known as the balance sheet-based aggregate accruals, Richardson proposed to measure the net change of all noncash accounts of a company’s balance sheet and adapt it as a ratio.

Similar to Sloan Ratio, the higher the changes in noncash accounts as expressed in accrual ratio, the lower the quality of earnings.

For example, if we want to measure the accrual ratio of AC Energy for 2020 based on balance sheet, we must first compute its net operating asset, which is simply getting the difference between its operating asset and operating liabilities.

We compute the operating asset of AC Energy by deducting its cash from its total assets to derive a value of P58.4 billion.

Its operating liabilities are computed by deducting its total debt from total liabilities to get an amount of P10.4 billion.

By taking the difference between the total operating assets and liabilities of AC Energy, we derive its net operating asset at P48 billion.

To measure the amount of AC Energy’s accruals for 2020, we simply compare this against its net operating asset in 2019 to derive a difference of P18 billion.

If we convert this as a ratio of average net operating assets of AC Energy, we will derive an accrual ratio of 46.1 percent, which is very high compared to the median accrual ratio of PSE index stocks at only 4.5 percent.

Now, if we look at the performance of PSE index stocks over the past seven years from 2014 to this year, we will find that the balance sheet-based accruals are negatively correlated to stock returns the following year in 12.5 percent of the time.

This means that the higher the accrual ratio of a PSE index stock, the greater the possibility that its stock price will fall one year after.

Based on this model, we estimate about 0.21 percent negative return for every 1 percentage point increase in balance sheet-based accrual ratio.

It is interesting to note that while accrual ratios can predict negative returns in future periods, the same ratios can also be used to predict positive excess returns in the short term.

Given the same historical data, we will find that the accrual ratios are positively correlated with price-to-earnings (PE) ratios of PSE index stocks during the first year in 24.8 percent of the time.

Using the same example, we will find that when AC Energy’s accrual ratio increased from 46.9 percent as of the end of 2020 to 82.5 percent for the first half this year, its PE ratio also rose from 82 times to 121 times.

This market anomaly is expected, as Sloan and Richardson theorized, that investors tend to overpay for high accrual stocks because of expected earnings growth.

But as studies have shown, earnings with higher accrual components are less sustainable than those with smaller accrual components, all else being equal.

Balance sheet-based accruals are as useful as the cash flow-based Sloan Ratios. Both ratios can be used to evaluate earnings quality of stocks and its potential impact on stock returns in the future. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 93rd batch of RFP program in January 2022. To register, email [email protected] or text at 0917-6248110