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Sloan ratio can help you beat the market
If you are using the new OSV Stock valuation and analysis spreadsheets, you would have noticed the addition of the accrual section. This article should help you understand accruals better and provide you with a guide on how to use the analysis spreadsheets better.
There has been a couple of posts on accrual accounting and what to look out for. If you get the chance, read these articles to learn more
- You Need to Determine Earnings Quality Through Accruals
- Checking Accruals of a Company in 5 Minutes
- Could You Have Predicted Diamond Foods Accounting Fraud?
Earnings in the Cloud
Earnings is the main word that holds the greatest importance on Wall Street. Ironically, earnings is not real money. $1 in earnings does not equal $1 in cash a company has to spend.
Earnings contain a lot of non cash earnings which is called accruals.
The non cash part of earnings includes such things as changes in accounts receivable where no cash has been exchanged, but companies will book such transactions as earnings under the accrual accounting method.
Don’t get the wrong idea that accrual accounting is bad or wrong. Cash accounting has some serious problems of its own but the weak area for accrual accounting is that it introduces subjective judgments and assumptions.
Analyzing accruals to pick winners is not a new concept.
Back in 1996, Richard Sloan, a former University of Michigan researcher, performed a study where he analyzed the performance of stocks based on their accrual ratio.
Sloan found that companies with low accrual ratios outperform companies with high accrual ratios.
Over a 40-year period between 1962 and 2001, buying the lowest accrual companies and shorting the highest accrual companies resulted in an average annual compounded return of 18% compared to the S&P 500’s 7.4% annual return over the same period.
Thus, he gave birth to what we now know as the Sloan Ratio.
Formula: The Secret Sloan Ratio
Sloan Ratio = (Net Income – CFO – CFI) / Total Assets
CFO = Cash From Operations
CFI = Cash From Investments
If the Sloan Ratio is between -10% and 10%, the company is in the safe zone and there is no funny business with accruals.
If the Sloan Ratio is less than between -25% and -10% on the negative side, and between 10% and 25% on the positive side, this is a warning stage of accrual build up.
If the Sloan Ratio is less than -25% or greater than 25%, and this ratio is consistent over several quarters or even years, be careful. Earnings are highly likely to be made up of accruals.
Formula: Balance Sheet and Cash Aggregate Accrual Ratio
Use this formula to calculate the balance sheet accrual ratio and cash flow accrual ratio.
Next, subtract last period’s NOA from the current NOA figure to arrive at Balance Sheet Aggregate Accruals.
The Balance Sheet Aggregate Accruals Ratio is determined by dividing that number by the average accruals.
The procedure is similar when calculating Cash Flow Aggregate Accruals, as shown below.
What to Watch Out For With Accruals
You now have the secret sauce to check accruals. Use it to watch out for the following.
- A jump in earnings accompanied by a jump in the accruals ratio should raise a red flag.
- A higher than industry-average growth rate with a higher than industry-average accruals ratio.
- High balance sheet accruals indicate that the company has expanded its asset base rapidly.
- High balance sheet accruals also have a higher ROE.
- Companies with high balance sheet accruals tend to have higher sales growth than low balance sheet accrual companies.
- Companies with low balance sheet accruals tend to have below average returns on equity. Analysts expect the company to lag.
- Balance sheet accrual can indicate whether capital is being used properly. A company with high accruals can come from acquiring or merging with companies which expands the asset base.
- Low balance sheet accrual companies tend to shrink their balance sheet through spin offs, share repurchases or large write offs. In these situations, it is usually removing bad performing assets or returning money to shareholders which is always a good use of capital.