6.16 Developing Professional Judgment using Decile Analysis

How Can You Interpret Earnings’ Quality Numbers?

Recall, in the earlier WMT example as well as in the above P&G reconciliations we observed some negative measures for earnings quality.   How does this compare with other firms?

In this section we will use the latest financial statement data available for these firms to illustrate how to interpret these ratios.

First, read in the entire dataset into Valuation tutor:

Step 1:  Click on the menu item Data and select Download Data:

Step 2:  Click on Yes when prompted

Followed by clicking on Download the FTS Dataset:

Step 3:

Now select Quality of Earnings and then click on Calculate for All (the button depicted below):

This computes the ratios for the entire population of stocks in the dataset:

Finally, to compute the Deciles and see where WMT and P&G currently rank click on the button “Calculate Deciles” (middle button in the above screen).

 This calculates the deciles for each variable:

 And scrolling across you can see that the cutoffs for the Earnings’ Quality deciles are:

That is, the lower bound of the 1^st decile (highest ratio) for the Accrual Ratio (Balance Sheet) is 0.30779.  That is, the asset scaled aggregate accruals is positive and 0.30779.  Observe, that the 7^th decile cutoff is negative, -0.01645.  This implies that net income is lower than the cash flows so the net effect of accruals is to reduce income.  As a result, if earnings management is happening using accruals the higher this number the more net income relies on accruals raises questions regarding the role of earnings management.  Similar, interpretations apply to the other two measures.   

Now consider where WMT and PG currently lie?

By entering the Ticker WMT you can see that currently (2011 10-K WMT’s earnings’ quality ratios are:

Or you can check it’s decile rankings directly from the list below the set of 10-decile cutoffs.

That is,

Aggregate Accruals (Balance Sheet) is 0.05215 in the 5^th decile,

Aggregate Accruals (Cash Flow) is 0.04986 in the 5^th decile,

Percent Operating Accruals is -0.4426 in the 5^th decile,

That is, for Wal-Mart currently all three measures produce the same decile ranking.  But this is not the case for P&G for which the 10-K 2011 rankings are:

Aggregate Accruals (Balance Sheet) is -0.05326 in the 8^th decile,

Aggregate Accruals (Cash Flow) is -0.03027 in the 8^th decile,

Percent Operating Accruals is -0.26193 in the 4^th decile,

That is, for PG the two asset based measures produce a more favorable ranking than does the income scaling metric. 

However, no flags are raised for either Wal-Mart or Proctor and Gamble from the earnings quality ratios.  The above exercise is designed to reinforce the importance of assessing ratios relative to some benchmark.  This is because the absolute number does not communicate a whole lot by itself.