I was recently introduced to an article by a reader on the M Score and have found it quite interesting and wanted to share it with you as well. I've summarized and edited parts of the original article.
The M score was created by Professor Messod Beneish. In many ways it is similar to the Altman Z score, but optimized to detect earnings manipulation rather than bankruptcy. This is the link to the original M score for earnings manipulation paper.
Beneish used all the companies in the Compustat database between 1982-1992.
The M Score Variables
The M score is based on a combination of the following eight different indices:
DSRI = Days' Sales in Receivables Index
- Measured as the ratio of days' sales in receivables in year t to year t-1. A large increase in DSR could be indicative of revenue inflation.
GMI = Gross Margin Index
- Measured as the ratio of gross margin in year t-1 to gross margin in year t.
- Gross margin has deteriorated when this index is above 1. 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.
- AQI is the ratio of asset quality in year t to year t-1.
SGI = Sales Growth Index
- Ratio of sales in year t to sales in year t-1.
- Sales growth is not itself a measure of manipulation. However, growth companies are likely to find themselves under pressure to manipulate in order to keep up appearances.
DEPI = Depreciation Index
- Measured as the ratio of the rate of depreciation in year t-1 to the corresponding rate in year t.
- DEPI greater than 1 indicates that assets are being depreciated at a slower rate. This suggests that the firm might be revising useful asset life assumptions upwards, or adopting a new method that is income friendly.
SGAI = Sales, General and Administrative expenses Index
- The ratio of SGA expenses in year t relative to year t -1.
LVGI = Leverage Index
- The ratio of total debt to total assets in year t relative to yeat t-1.
- An LVGI >1 indicates an increase in leverage
TATA - Total Accruals to Total Assets
- Total accruals calculated as the change in working capital accounts other than cash less depreciation.
The Beneish M Score Formula
The eight variables are then weighted together according to the following:
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
A score greater than -2.22 indicates a strong likelihood of a firm being a manipulator. 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.
The 5 Variable Version of the Beneish Model
The five variable version excludes SGAI, DEPI and LEVI which 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*DEPI
M Score to Select Stocks
In 2008, Beneish goes into more detail in another paper that he published titled "Identifying Overvalued Equity" which seeks to use the M score to select stocks.
Beneish examines portfolio deciles based around his M score over the period 1993-2003 with annual rebalancing done four months after the financial year end.
The results produce 14% for the 8 variable model and 14.8% for the 5 variable M score version where the top M score stocks were held long while the lowest M score stocks were shorted.
Download M Score Spreadsheet
This article wouldn't be complete without a supporting spreadsheet of course. Here is a spreadsheet that you can try out for yourself. The prior 2 years and TTM figures are used to calculate both the 5 variable and 8 variable version of the M score.
Do you use the M score model in your analysis? If so, how?
Install Instructions
Download the install guide and follow the instructions.
Download Randy’s mind blowing SMF excel Add-in in order to retrieve the data automatically, otherwise you will just get a bunch of #NAME errors.
(Go to the SMF Yahoo group for more info)
1. Navigate to Local Disk C: in My Computer or Explorer
2. Create a new folder called “SMF” without the quotations
3. Copy or cut the RCH_Stock_Market_Functions.zip file to the SMF folder
4. Unzip the contents to the directory. DO NOT unzip the contents inside another folder. All the contents should be within the SMF Add-In folder.
BONUS
As an added bonus, a reader took the liberty of creating a stock watchlist spreadsheet after reading my post on how to create an investment tracking spreadsheet on Google Docs.
With the spreadsheet, you enter the ticker, the margin of safety price and the expected sale price and the rest is calculated for you. Very quick and easy. Just my style.
So thanks to Mithilesh for sending it my way and wanting to share it with you.
Stock Watchlist Spreadsheet
Read original blog post
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