Detect Earnings Manipulation with M Score

Jae Jun

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.

To download the spreadsheet, you must go to the main page of Old School Value and sign up with your email to receive a list of free spreadsheets.

The list includes nine free spreadsheets, the add-in required to download data from the internet as well as all the installation help material.

Premium Spreadsheets

Feel free to check out the free version and then when ready, go to the stock valuation software page and review what you will get with the premium.

The premium version includes several valuation models as well as fundamental analysis data, historical data, charts and competitor comparison features. Just by entering one ticker, you can immediately get all that information on your favorite stock which will save you hours in your analysis.

Go now and see for yourself why people rave about the spreadsheets.

IMPORTANT!

Please read the installation guide and FAQ.

To date, I’ve been spending hours helping people with simple excel issues on a free product rather than anything spreadsheet related.

So for all excel and install problems, place all questions in the comment sections below. That way I won’t have to answer the same question again and again.

Beneish M Score Spreadsheet Screenshot

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