The First Cut: Stocks With Low Accrual Ratios
The First Cut is designed as a starting point for investors. Each issue we list the top 30 stocks that pass relatively simple screens of interest to individual stock pickers. AAII’s Stock Investor Pro screening software is used to generate the First Cut listing.
Are earnings from all companies equally comparable?
The answer is no and has much to do with accrual accounting, which attempts to match expenses to revenues when the revenues are recognized. Accrual accounting introduces many interpretations and estimates by management into the financial statements. Decisions regarding the recognition of revenue, creation of reserves against losses, build-up of inventory, and even extension of credit to customers are examples of factors that may impact earnings comparability. A number of studies have found that it can be profitable to build portfolios with companies that actually generate more cash than their accrual earnings indicate.
The accrual ratio is a popular measure to identify firms with low non-cash or accrual-derived earnings relative to their cash flow. In its most simple form it is calculated by subtracting free cash flow from net income, dividing the result by total assets and presenting the figure as a percentage. Free cash flow is derived from the cash flow statement and is calculated by subtracting capital expenditures and dividends from cash flow from operations. When free cash flow is greater than net income, cash earnings are higher than accrual earnings and the accrual ratio is negative (good).
For this issue’s First Cut, we screened for companies with positive historical and expected earnings, but with negative accrual ratios over the latest 12 months and last fiscal year. The First Cut universe was limited to domestic, exchange-listed stocks with a share price above five dollars. Financials were excluded because their unique financial structure cannot be directly compared to firms in other industries. The 30 stocks with the lowest current accrual ratio made the First Cut. The price-earnings ratio and price-to-free-cash-flow ratio provide a feel for the valuation level of the passing stocks. The total assets figure indicates the size of the firms, while the 52-week price change highlights the recent price performance.
Keep in mind that all screens are starting points; the goal of the accrual ratio screen is to create a list of stocks that might be performing better than indicted by their reported earnings.