Relationship between accounting quality and share prices:: Ambit

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Relationship between accounting quality and
share prices
Whilst at the level of the overall market, the link between share price
performance and accounting quality is not visible, the relationship can be clearly
seen at the sectoral level (particularly if we slice the sectors into different market
cap buckets). So, for example, for large cap IT stocks, the correlation between
share price performance (FY07-10) and change in the blended accounting score
(FY07-10) is 97%. Another example — for large cap stocks in the metals and
mining sector, the correlation between the FY11 P/E and the blended accounting
score is 33%.


In fact, in 80% of the sectors in the BSE500, there is a direct correlation
between share price performance and the blended accounting score (i.e.
higher the score, higher the share price performance for that particular sector).
The only sectors where we are not able to pick up such a correlation are Capital
Goods, Diversified, Housing related and Tourism.

Moreover, when we break the BSE500 into four market cap buckets (with bucket
1 being the 50 largest companies by market cap and bucket 4 being the bottom
half of the BSE500), we find a direct relationship between share price
performance across buckets and the blended accounting score across FY07-10
(i.e. higher the score, the better the share price performance for that particular
bucket). In particular, buckets 1, 2, 3 and 4 with blended accounting scores
across FY07-10 of 224, 204, 190 and 181 respectively have shown share price
performance (FY07-10 CAGR) of 23%, 19%, 9% and 4% respectively.

However, when we look at the average annual change in the blended
accounting score, we note that bucket 1 has performed the worst - it has the
highest decline in its average annual score over FY07-10, with the worst decline
in FY10. Interestingly, bucket 1’s share price performance seems to reflect this
— in FY10, bucket 1 saw the lowest share price appreciation.

Moving away from share prices, if we focus purely on accounting quality over
time, a few findings leap out:

 The CFO/EBITDA ratio deteriorated dramatically in FY08, the final year of
the previous bull market. From that perspective, the healthy CFO/EBITDA
ratio for FY10 gives cause for cheer. However, based on discussions with our
sector leads, we also feel that this ratio is likely to fall in FY11. That in turn
suggests that investors need to be on their guard.

 There are two other grounds for concern with regard to revenue recognition.
First, just as in FY08, so in FY10 debtor days are increasing suggesting
weakening operating cashflows and/or more aggressive revenue
recognition. Second, audit fees as a percentage of revenues have risen in
FY09 and FY10.

Accounting quality: Differences across sectors
Based on the blended accounting score (across FY07-10) Tourism, Textiles
and Media emerge as the worst three sectors with average score of 181, 169
and 164 respectively which is 18% below the overall BSE500 average.

Furthermore, across the four financial years in question, Textiles (across all
years) followed by Media (present in three years) stand out consistently as the
sectors with the weakest accounting.

FMCG, Transport Equipment and Telecom emerge as the sectors with the
strongest accounting quality with scores of 215, 215 and 213 respectively, which
is 10% above the BSE500 average score.


Housing related companies (which as per the BSE500 definition includes
cement, EPC and realty stocks) is the biggest contributor to the 50 weakest
companies ranked by accounting quality. Furthermore, barring one year (FY07
wherein it was ranked second in the bottom 50 category) housing related
companies have been the biggest contributor to the bottom 50 list across all
years. Pages 17-18 provide more detail on why Housing related companies
consistently feature prominently in the bottom 50 list.


Accounting quality: Differences across auditors
The blended accounting scores differ significantly across the major auditors in
India. Most notably, the Indian arms of the large foreign accounting firms
– SR Batliboi, BSR, Deloitte and PWC – seem to produce better accounting
scores than the home grown auditors.
Whilst PWC firm has the most audit clients in our dataset, amongst the auditors
with more than five clients in our dataset, SR Batliboi has the highest blended
accounting score across FY07-10 (see pg 12). On the other hand, Haribhakti,
amongst the large auditors in the Indian market, has the biggest improvement
in its accounting score across FY07-10.
We also find that there is a negative correlation between the blended
accounting score and audit fees as a % of revenues i.e. companies which pay
their auditors more seem to have lower accounting scores.


How can we help investors?
In response to these challenges facing our clients, our value proposition to
clients is twofold:
 For clients who are willing to share their portfolio composition with us, we
can share with clients the blended accounting scores of these companies.
For companies receiving weak accounting scores, we can highlight the
underlying drivers of such scores. Please note that we provide such a service
only for the current BSE500 excluding Financials.
 Whilst in our ongoing published research we will focus on the broader
aspects of corporate governance, for clients who are interested in a deeper
dive, we provide a bespoke research service which includes a
comprehensive analysis of the promoter’s integrity, board composition and
competence and insider trading patterns.