What are the top 5 Nigerian stocks with great earnings quality?
Earnings quality. Have you heard that term before? You might think “hey, earnings are calculated by the firm and very often, verified by auditors so what’s the deal with earnings quality? Why would there be high-quality and low-quality earnings?
This post will briefly explain the reason for analyzing earnings quality and also walk through a method for identifying Nigerian stocks with great earnings quality.
Firms face pressure, the type many investors have no clue of. Let’s explain this using an imaginary company called EgoBros Nigeria Plc (EgoBros). EgoBros, like every other profit-making business, raises capital from investors and debtors (stakeholders). By entrusting their resources (equity or debt) to EgoBros, these stakeholders have expectations of EgoBros.
The expectations, explained in the previous paragraph, often put pressure on companies to do (or not do) certain things. Examples of such pressure include:
Compliance with lending agreements
Some firms, while trying to raise capital go into debt covenants. Just in case you don’t know what a debt covenant is, think of it this way. Let’s assume that EgoBros borrows some money from a lender who agrees to lend to EgoBros on strict terms like EBITDA remains a certain percentage of total assets, etc. You can get an introduction to the need to understand the financial health of companies in this post, “Stock Price and Fair value”.
Due to terms like these, EgoBros will have to operate within the confines of these terms it agreed with its lenders. If EgoBros does not operate within these agreed-to terms, ultimately the lender can come in and call in the loan. This can quickly build up pressure to comply with issues like debt covenants.
Meeting or exceeding analysts’ targets.
Analysts follow companies and come up with an idea of what they think a firm’s earnings will be in a given period (quarter or year). If the firm doesn’t meet that target, there could be repercussions. These repercussions could mean that the analyst(s) might decide to downgrade the stock and, for example, change its rating to a sell.
Repercussions like this ultimately come back to hurt management; they might ultimately end up getting fired because “they’re not meeting the targets”. In summary, public firms have a very strong incentive to meet analysts’ targets.
Most people with an eye on the market have expectations of listed companies. There is a sustained pressure on companies to constantly show growth in performance (ultimately, in profitability). The market, a collection of investors, demands, and rewards consistent growth.
If we graphed the expectations of the market for companies, it would look like a smooth upward sloping chart. The market wants to see earnings going up, nicely and smoothly, with very little fluctuations. In reality, though, good things don’t always happen to good people (and good businesses too). Things go wrong and it is the managers’ responsibility to steer the ship to safety and continue its course. Earnings cannot always continue to move up in a straight line – it just doesn’t work that way.
The reality that happens to businesses, making their earnings fluctuate, is what the market has coined a term for – volatility. As the earnings fluctuate, the market rewards (sells) and punishes (buys) the stock, causing a volatile price movement of the stock. Many investors do not like the unpredictability caused by the volatile stock price movements and will usually stay away from such stocks.
Let us assume, once again that EgoBros has been hit hard by reality in the last two years and it doesn’t look like things will improve drastically this year. What do you think its management will do? Well, the firm is going to do something, popularly called, earnings management.
What is “earnings management”?
You may be wondering, “what is earnings management?”. In simple terms, earnings management is the process of manipulating the numbers reported in financial statements. I don’t mean to imply manipulation that is associated with fraud, although when employed extremely, earnings management quite often ends up being a fraud. What I mean here when I talk about earnings management is when a firm “times its transactions”.
Earnings management is a process that firms use to time their transactions to produce gains and losses in order to smooth out earnings. Think of EgoBros having some unrealized gain on an asset that it had no desire to sell. If its management’s assessment indicates that there could be a dip in performance, it could *cushion* that dip by selling off those assets it hitherto had no plan to sell and realize those gains immediately. This kind of action could keep earnings in the trajectory that the market rewards.
What is earnings quality?
When we think about the idea of earnings management, it becomes clear why we classified earnings quality into high and low quality. When a firm engages in earnings management to a significant extent, we would say that that firm has a low earnings quality. Let’s think about a firm that is seriously playing games and timing transactions to make its earnings number meet a certain Target. It does not mean that the firm is engaged in fraud. It only means that its earnings We would say that that firm has a low earnings quality is not fantastic. It simply means you may have concerns about the trustworthiness or reasonableness of that earnings number.
When we look at net income on EgoBros’ income statement, for example, and we want to know how much of that income was truly generated and how much of it was transaction timing? If most of it is a financial engineering game, then we say that that firm has low earnings quality.
What determines a company’s earnings quality?
It should be clear now, by now, that timing transactions can be used by a firm’s management for both positive and negative purposes. What you also need to understand is the impact that earnings management can have on companies’ results.
Public companies have an obligation to report their financial positions and performances. In order to prepare such results, standards are given which makes it easy for investors to understand the results. The standards also make it possible to conduct a peer to peer review, since it is expected that companies use a common reporting standard.
“IAS 1 – Presentation of Financial Statements” is the accounting standard that covers how companies should handle several topics including accruals. When transactions are recorded in the books of accounts as they occur even if the payment for that product or service has not been received or made, it is known as accrual-based accounting. One of the creative outcomes of accruals accounting is the ability to “time transactions” as explained earlier.
Ultimately, accruals-based accounting is key to determining whether the earnings quality of the company is high or low grade.
How do you measure earnings quality?
Now that we know that accruals are the primary tool that management employs when trying to manage its earnings figure, we set out to find a way to measure the accruals in a company’s reported earnings. We found one!
A researcher at the University of Michigan analyzed stock performances based on their accrual ratio. He made a discovery; companies that had low accrual ratios outperform those with high ratios. His study, “Do stock prices fully reflect information in accruals and cash flows about future earnings?”, showed that between 1962 and 2001, buying companies with the lowest accruals and selling companies with the highest accrual resulted in an average annual compounded return of 18% compared to the S&P 500’s 7.4% over the same period. His method is now popularly known as the Sloan Ratio.
How to find stocks with high earnings quality using the Sloan Ratio
Remember that the purpose of this article is to identify companies that have great earnings quality. According to Sloan, a company’s earnings should be generated primarily form its operations and investments. Therefore, any other category of income that significantly adds to the earnings for the period should be treated as suspect (there are cases when the company has legitimate reasons to do this).
The Sloan Ratio, therefore, tries to identify non-operating and non-investment related earnings. The formula for the Sloan ratio, therefore, is:
Net Income (NI) minus (Cash Flow from Operations (CFO) plus Cash Flow from Investment (CFI)) divided by Average Total Assets (TA)
(NI – (CFO + CFI)) / TA
The result will be a ratio which has been classified into:
High Earnings Quality – Ratios between -10 and +10
Average Earnings Quality – Ratios between -25 and -10 or between +10 and +25
Low Earnings Quality – Ratios consistently (over multiple periods) lower than -25 or greater than +25.
Therefore, according to Sloan’s model, a company with a score between -10 and +10 is in the safe zone and there is little evidence of accruals-based earnings management. For companies with the ratio between -25 and -10 or +10 and +25, it is a warning of accrual build up. For companies with scores that have been consistently lower than -25 or greater than +25, you may just be looking at a company whose earnings figure is likely to be made up of accruals.
Top Nigerian stocks with high earnings quality
The image below is part of a list of Nigerian stocks that were filtered using the Richard Sloan ratio (given above). The formula in the preceding paragraph was applied and coded into our screener, making it super simple to always find top-quality stocks. The formula included a filter to show only stocks with the following characteristics:
stocks with Sloan Ratios that are between -10 and +10
stocks with positive earnings in the last financial year
stocks with a price to earnings ratios between 0 and 10
stocks that paid dividends in the last financial year
The result was then sorted to show the stocks with the highest dividend yields first.
From the list above, we can see that based on all the information available to us today, 29th August 2020, the top five stocks on the Nigerian Stock Exchange that have a high quality of earnings and also show some terrific value (low price to earnings) are:
If you would like to see the full list, you can head over to the Investor Hangout data hub and recreate the filter, using the rules editor, with the values indicated below. Remember to select the necessary data columns in the search bar, highlighted with the red rectangle, and titled “Columns (284):” below.
If you are like me, however, and you like ready-made stuff, you can take up a trial subscription to the Investor Hangout and get access to this Richard Sloan Quality screener as well as many other powerful screeners as well. No need to worry about recreating the screener. Just log-in and get up to date lists of top-quality stocks.
This has been the first in a series of posts that go into the nuts and bolts of identifying great investment opportunities in the Nigerian Stock Exchange. We have learned that listed companies are under a lot of pressure to deliver financial results that are attractive to the market (earnings growth). We have also learned that this pressure, sometimes compel company management to manage their earnings and ultimately improve the look of their performance.
We found a model, Richard Sloan’s Sloan Ratio, which seeks to track the quality of earnings of companies and to identify whether the earnings show signs of financial engineering. We applied the Sloan Ratio to the stocks listed on the Nigerian Stock Exchange and displayed the result of the top five with links to where you can re-create the model whenever you want.
I have enjoyed making this presentation and hope you have enjoyed reading it as much as I have made it. If you enjoyed it, please remember to hit the like button below. If you know someone who would benefit from the knowledge in this post, be a cheerful giver and hit the social media buttons to share the links with them. Till we connect again, trade responsibly, and have a great week in the market!
Taiwo Megbope is the Co-founder and Chief Growth Officer at Investor Hangout.
He is tasked with ensuring and managing the growth of the Investor Hangout project. His responsibilities include creating and implementing the project's vision as well as executing growth-generating strategies.
Taiwo is an avid researcher and autodidact. In his spare time, he enjoys spending time with his family and friends.