How does balance sheet growth affect equity returns?

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Last week we touched on in this “How to Beat the Market with Sloan Ratios” column that the stock market in general cannot distinguish between cash gains and accumulated gains.

For this reason, investors often overestimate the cumulative portion of a company’s earnings, which is relatively inferior in quality to the cash portion, resulting in a significant mispricing of stocks.

We introduced the use of the Sloan ratio to measure the extent of company exposure using net income and free cash flow, and found that the greater the Sloan ratio of an index stock by the higher the Philippine Stock Exchange (PSE), the lower the share will be. fall in three years.

In 2006, a team of researchers from the Wharton School of the University of Pennsylvania led by Scott Richardson suggested that another way to measure regulation ratios was to use balance sheet data.

Richardson explained that accrued profits were viewed as growth in a company’s operating working capital, which was part of its total assets.

Increases in receivables such as increase in accounts receivable, capitalization of expenses or recognition of goodwill also increase total assets.

Known as aggregate balance sheet-based run-ups, Richardson proposed to measure the net change in all non-cash accounts on a company’s balance sheet and fit it as a ratio.

Similar to the Sloan ratio, the higher the changes in non-cash accounts expressed in the accrual ratio, the lower the quality of income.

For example, if we want to measure AC Energy’s build-up ratio for 2020 on a balance sheet basis, we first need to calculate its net operating assets, which simply gets the difference between its operating assets and its operating assets. operating liabilities.

We calculate AC Energy’s operating assets by deducting its cash from its total assets to arrive at a value of 58.4 billion pesos.

Its operating liabilities are calculated by deducting its total debt from total liabilities to arrive at 10.4 billion pesos.

By taking the difference between the total operating assets and liabilities of AC Energy, we derive its net operating assets to be 48 billion pesos.

To measure AC Energy’s accrued liabilities amount for 2020, we simply compare it to its net operating assets in 2019 to get a difference of 18 billion pesos.

If we convert this to the average net operating assets ratio of AC Energy, we will get a settling ratio of 46.1%, which is very high compared to the median settling ratio of PSE index stocks at only 4.5%.

Now, if we take a look at the performance of stocks in the PSE index over the last seven years from 2014 to this year, we will find that balance sheet-based run-ups are negatively correlated with stock returns the following year in 12.5. % time.

This means that the higher the accumulation ratio of a PSE index stock, the greater the possibility that its stock price will fall a year later.

Based on this model, we estimate a negative return of about 0.21% for every 1 percentage point increase in the balance sheet-based accrual ratio.

Interestingly, while accumulation ratios can predict negative returns in future periods, the same ratios can also be used to predict positive excess returns in the short term.

Based on the same historical data, we will find that the accumulation ratios are positively correlated with the price / earnings (PE) ratios of the PSE index stocks in the first year 24.8% of the time.

Using the same example, we will find that when AC Energy’s accumulation ratio fell from 46.9% at the end of 2020 to 82.5% for the first half of this year, its PE ratio also increased by 82 times. at 121 times.

This market anomaly should, as Sloan and Richardson theorized, make investors tend to overpay for high cumulative stocks due to expected earnings growth.

But as studies have shown, incomes with higher components of accumulation are less durable than those with smaller components of accumulation, all other things being equal.

Balance sheet-based accruals are as useful as Sloan ratios based on cash flows. Both ratios can be used to assess the quality of stock earnings and its potential impact on future stock returns. INQ

Henry Ong is a registered financial planner with RFP Philippines. Stock market data and tools provided by First Metro Securities. To learn more about investment planning, attend the 93rd round of requests for proposals in January 2022. To register, send an email [email protected] or text to 0917-6248110

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