How does earnings manipulation affect stock returns?
Two weeks ago, we discussed in this column how companies use accounting techniques to inflate their earnings to meet market expectations.
We recall that the common characteristics of earnings manipulators are those that grow extremely fast in terms of sales. They also experience deteriorating margins, rising administration expenses and increasing reliance on debt financing.
Because of these, earnings manipulators adopt aggressive accounting practices that result in unusual accumulation of receivables, increase in expense capitalization, decline in depreciation costs and buildup of noncash profits.
Through the use of the Beneish M-Score, we can uncover companies who are likely to be manipulating their reported earnings.
Companies that score greater than -1.78 are identified as earnings manipulators, while those that score lower than -2.22 are non-earnings manipulators.
In 2005, professor Messod Beneish, who developed the Beneish M-Score, revealed in his research that companies with high M-scores had lower future earnings and lower stock returns.
Beneish explained that since investors in general did not fully understand the implications of undetected manipulated earnings, companies with high M-scores had overvalued stocks, which could correct later resulting in lower returns.
When Xurpas listed in late 2014, it was touted as a promising high-growth technology stock. Its price skyrocketed more than four times its IPO price during the following year, as investors drove up the stock on high expectations.
Xurpas pursued growth by acquiring companies using the proceeds from the IPO and did not disappoint the market when it reported a 135-percent growth in sales and 29-percent earnings growth by end of 2015.
While investors cheered the results and pushed its stock price even higher during the first quarter of 2016, Xurpas’ underlying financials were showing a different narrative.
Xurpas’ M-Score increased from -4.84 in 2014 to a positive 6.10 in 2015, which was way higher than the -1.78 cutoff. By Beneish’s definition, the high score identified the company as a potential earnings manipulator.
As if investors have fully assessed the consequences of the company’s high M-Score, Xurpas’ stock price corrected sharply as it lost as much as 60 percent from its all-time high in 2016.
In early 2017, Xurpas reported that its total sales in 2016 continued to grow strongly by 114 percent. This aggressive sales growth helped increase its net income by 32.8 percent, which was very impressive.
But a closer look at Xurpas’ M-Score for 2016 would show that the company had a -1.61, which was again higher than the -1.78 cutoff, raising the likelihood that its earnings were manipulated.
As a result, despite the strong earnings growth, Xurpas’ stock price in 2017 declined further, falling as much as 49 percent from its highest price during the year.
That same year, Xurpas’ overstated earnings began to correct when its net income fell by 66 percent. By 2018, the company succumbed to a net loss of P811 million as its total sales declined by 41 percent.
The subsequent lower earnings results of Xurpas, as theorized by Beneish, resulted in lower returns, as its stock price fell to its all-time low by the end of 2018.
If we classify all listed companies in the Philippine Stock Exchange into earnings manipulators and non-earnings manipulators according to their M-Scores, we will find that stocks with lower M-Scores tend to outperform those with high M-Scores.
For example, if we look at the historical performance of earnings manipulators in 2018, we will find that their average return after one year in 2019 was a negative 8.4 percent.
If we compare this to the group of non-earnings manipulators in 2018, we will find that their average return the following year was a positive 1.5 percent.
Again, if we repeat the same process in 2019, we will find that the group of earnings manipulators had an average return of positive 2.4 percent in 2020.
But if we match this against the group of nonmanipulators, we will find that their average returns in 2020 were higher at 8.8 percent.
Companies with high probability of earnings manipulation are likely to have lower returns in the future because lower earnings quality and higher equity risk lead to lower share price valuation. 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 this January 2022. To register, email [email protected] or text at 0917-6248110
