The Beneish & Nichols O-Score: Identifying Overvalued Stocks for Short Selling & Loss Avoidance

Overview

The O-Score is a short-selling screen based on identifying firms with a high likelihood of earnings overstatement, as well as unrealistic market expectations, poor current operating cash flow, a history of merger activity, and recent / excessive issuances of stock.

Background

Following on from the review of Beneish’s MScore research, it's worth examining the subsequent work by Beneish & Nichols to develop the O-Score (i.e. Overvaluation Score). This is a screening approach which combines the likelihood of fraud with other characteristics capturing value -destruction in order to identify substantial overvaluation. In particular, the O-Score implements a number of conclusions from Michael Jensen's 2005 paper. This outlined the characteristics of overvalued firms with poor managers as including i) weak fundamental performance, ii) a history of acquisitions (particularly where these have been paid for with stock and involve public targets), iii) excessive investment and equity issuance and iv) unrealistic market expectations.

Why is It Interesting? 

As the authors themselves note:

“Our results should be of interest to investors who want to avoid large wealth losses, directors who want to identify unrealistic market expectations, and auditors and regulators who want to identify firms with a high risk of accounting impropriety”.

Indeed! such a screen could potentially be used to identify short candidates for those brave (and liquid) enough to consider short-selling, or - more prudently - as a loss-avoidance screen to avoid overvalued companies.

Calculation of the O-Score

The O-Score ranges from zero to five. Firms receive one point if any of the following is true:

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• A high likelihood of earnings mis-statement, specifically, they have an M-Score in the top 20%.
• Low operating cash flow to total assets (they fall in the bottom 20% in terms of cash flow-to-total assets) following research Desai, Rajgopal, and Venkachatalam (2004) that firms with low CFO/P subsequently earn lower returns.
• High sales growth (they fall in the top 20% in terms of sales growth) following research which suggest that Wall Street is invariably surprised by high sales growth firms that fail to sustain this performance.
• It has engaged in a merger or acquisition in the last five years. This is consistent with prior research that has shown that many mergers destroy shareholder wealth.
• Unusual amounts of recent equity issuance, i.e. it has issued equity in excess of the industry median in the last two years. This is based on research that argues that managers prefer to issue (not to issue) shares if they perceive that their stock is overvalued (undervalued).

Does the O-Score work?

According to the research, the O-Score model predicts year-ahead abnormal stock price declines of over 25%. The findings are apparently stable by year and for different levels of market capitalisation.

Firms with O-Scores equal to five were also shown to be nearly five times as likely to restate the current period’s earnings at some future date.

Watch Out For

The study excluded financial services firms, firms with less than $100,000 in sales or in total assets, firms with market capitalization of less than $50 million and firms without sufficient data to compute the probability of manipulation.

The Source: 

You can read the paper "Identifying Overvalued Equity" by Beneish & Nichols here.

Other Sources: 

• Empirical Finance on the Ultimate Short Book
• Old School Value: Short-selling Thread
• James Montier - Joining the Dark Side: Pirates, Spies and Short-sellers