What You Will Learn
- How to detect earnings manipulation using Beneish M Score
- How to use the 5 variables of Beneish M Score for flexible valuation
Beneish M Score Introduction
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 Beneish 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 Beneish M Score for earnings manipulation detection paper.
Beneish used all the companies in the Compustat database between 1982-1992.
The Beneish 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.
But before I get into the analysis, click on the image below to get the investing red flags that will help you detect potential blow ups. You’ll also get exclusive content and resources that we don’t share anywhere else.
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 -1.78 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
Using the Beneish 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 the Free Beneish M Score Spreadsheet
This article wouldn’t be complete without a supporting spreadsheet of course.
You can download a spreadsheet that will automatically pull in the required financial data to calculate the Beneish score for the prior 2 years and TTM. Both the 5 variable and 8 variable version of the M score is included.
To download the spreadsheet, sign up for the Old School Value email list using the form right at the bottom of this page.
You will receive a list of all the other free spreadsheets, the excel add-in from the SMF group required to download data from the internet as well as all the installation help material.
And that is how you calculate the Beneish M Score.
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