Beneish M Score Formula Above -1.78 Detects Earnings Manipulation

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.

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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 versions of the M score are included.

To download the spreadsheet, click here.

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And that is how you calculate the Beneish M Score.

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