How Managers Manipulate Earnings And How To Avoid Value Traps by Bill Achola
Have you ever seen a cheap stock and jumped up with excitement? Only to have all the joy dissipate within a few months of purchasing the stock, as the price of the stock kept going down.
You along with other investors that shared your enthusiasm for the stock found themselves sucked into a value trap set by managers that manipulated the earnings.
An American dream turned sour, something that has happened far too many times in the past, but now, it needs to be put to rest.
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Awareness to future and current investors about how managers manipulate earnings and how investors can save themselves from the clutches of a value trap need to be laid out.
What are Value Traps?
Value traps attract investors by creating a façade of a profitable stock to invest in, as the stock trades lower than its intrinsic value.
The company portrays a glamorous image of buying stock, outlining the following benefits:
- We will generate a consistent and increasing cash flow for our shareholders
- Our business plan lists products that are guaranteed to have strategic gains in the market
- We only produce and provide our shareholders with unambiguous financial statements
- Shareholders will be buying stock at a price lower that the stock’s actual price, thus providing them with a margin of safety
However, as you may already know statements such as this can be far from the actual truth, as it serves as the basis for reeling in investors to buy a share in their company.
To give the company the benefit of the doubt, they might not have been trying to defraud you, but misinterpretations of the accounting rules and rigorous financial practices might have skewed the financial statements, resulting in manipulation of earnings.
The company to live up to the expectations of the investors might not be able to maintain steady and stable earnings and sales growth, as they had depicted in their business plan.
Now, the company is under immense pressure to rectify the situation so they end up pressuring their staff to work overtime, resulting in more costs.
Unable to make the sales quota each month, they force the manager to come up with numbers to make investors and financial analysts believe that they are in a good place in terms of earning and sales growth…they are not.
The company with the assistance of the manager has just committed financial fraud, and you have become a victim of a value trap.
The Types of Value Traps an Investor Needs to be Alert For
Managers use more than one technique to make investors such as you a fool into believing that a stock in their company will help you live the American dream.
To you, it is a value investing opportunity, and you are quick to take it.
By choice, you might be a value investor looking to buy stocks in companies that you believe financial analysts have undervalued in the market.
When the price of the stock deflates, you earn.
However, as you know by now, that is not always the case, as you could be falling into a trap established by managers.
Value investing can be profitable, but not when the following traps are set in motion:
- “Cookie-jar” Reserves
The accrual of expenses occurs when the manager creates reserves using profits accumulated during a company’s good financial period. This allows the company to smoothen out instability in its financial statements and misleads investors into thinking that the company is meeting all their targets.
- “Big Bath”
“Big Bath” or one-time charges occur when the CEO of the company is unable to meet the earnings targets. The CEO shifts the profits forward-prepays expenses, takes write-offs, or delays the realization of revenues.
- Modification of Operating Activities
Managers will modify when an event took place by placing them under a time period that was most profitable to the company. In doing so, it would result in higher sales in a certain month.
- Revenue Recognition
Managers strategize to provide incentives to their employees to increase sales by working overtime. This enables them to use income that they have not collected as revenue to increase sales for that year.
- Immaterial Misapplication of Accounting Principles
Managers do not correct errors in the financial report, as it paints a false picture of the company’s success in the growth of sales and earnings.
Investors do not know what is happening behind the scenes of a company so they unknowingly invest, putting their financial future in jeopardy.
With the stock relentless on improving, the stock prices drop, and they keep on dropping. The only way out of this mess is for you to sell your stocks at a great loss.
Do not hold onto the stocks, hoping it would improve, but sell it as soon as you suspect you have been set up.
Learn to Identify Value Traps
In order for you to avoid value traps altogether, you need to learn to identify if an investment is a value trap or an American dream:
a. Is the Industry the Company is catering to on a Decline?
Companies that cater to a market that cannot support itself in a dying industry will not increase in value overtime, as it will have to fight with other similar companies to attain the small market of people that still want to purchase from them.
For instance, Warren Buffet saw himself falling into a value trap when he bought Berkshire Hathaway, a failing textile company. He used his smarts to transform the company into an insurance company.
b. Is the Progression of Technology Hindering the Companies Progress?
Progression of technology can have a negative effect on a company’s sales and revenue. Just look at Blockbuster, the company went from generating two billion to 500 million in 18 months.
c. Is the Company Knee Deep in Debt?
Companies that are unable to repay debt will likely sink and go into bankruptcy, but will try to hold on to what is left of it as long as it can, even if that means manipulation of the financial statements.
d. Does the Company Use Aggressive Accounting Practices?
To stay on top, the company might use flawed accounting practices to make their stock appear favorable.
An example of a company that used aggressive accounting practices is Parmalat, an Italian dairy company.
In 2003, people bought stocks in the company as according to their financial statement; it exhibited a strong balance sheet and cash position.
However, the company collapsed the same year with 14 billion pounds in debt.
e. Is the Company Excessively Revising their Estimate Revisions?
Companies that regularly revise their estimate revisions should be seen as a sign that they are unable to forecast properly.
As the godfather of value investing, Benjamin Graham once said, “Even the intelligent investor is likely to need considerable willpower to keep from following the crowd.”
Do not follow the crowd, but use your mind to see the stocks as they really are, and not on how they appear to be.
Now, we want to hear from you.
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About the Author
Bill Achola is a financial publisher who owns a fast-growing, dynamic and innovative investment blog that empowers investors to make the right decision. To see action on how you can invest in your future, check out his popular post about 15 Jaw Dropping Tips for Investing in Gold & Silver. (and maybe learn to earn some profit from your investment while you’re at it).