The Applied Finance Group’s (NYSE: AFG) Earnings Quality variable is an important indicator of companies that may be more likely to have negative earnings surprises and underperform due to high amounts of accruals. With many firms under pressure to meet sales expectations in the current environment, it is important to watch out for those firms that may be trying to pad their sales numbers, ie. Channel stuffing (sending excess inventory to stores that cannot sell their products).

The EQ score ranges from 1 to 100, 1 being the best EQ score resulting from the lowest accruals, and 100 being the worst EQ score indicating the highest accruals. Because high EQ score companies (bad Earnings Quality) are more likely to have negative earnings surprises, you may want to avoid these firms. Our back-test indicates that the EQ variable works well as an exclusionary variable coupled with AFG’s valuation model.

We screened the S&P500 to identify those firms with the worst Earnings Quality (EQ), which may be possible torpedoes. The Chart Below displays the 14 firms along with their EQ scores and our valuation analysis.

Earnings Quality: Accruals

•An accrual is the difference between Cash Flow and Net Income.

•Net Income = Cash Flow + Accruals

•Low Accrual companies outperform high accrual companies

Two ways to approach accruals:

1. Cash Flow Statement
•Difference between Net Income and Cash Flow

2. Balance Sheet
•Change in Net Operating Assets from Period t-1 to t
•Net Operating Asset equals Total Assets Less Cash, Less Non-Debt Liabilities (excl. Minority Interest)

-Our studies show that the Balance Sheet approach is superior to the Cash Flow Statement approach.

-We found the Balance Sheet approach is also easier to expand to international companies.

 14 Worst Earnings Quality Firms

Here is a look at how well the Earnings Quality variable works when you split top half vs.