Many investors look at growth stocks to find the next big thing: the next Apple (AAPL) or Google (GOOG). Unfortunately, growth stocks usually come with higher risk due to their expensive valuation and weak financial condition.
Accounting professor Partha Mohanram developed a financial indicator that can help investors reduce that risk and find the best investment opportunities in the growth stocks landscape.
So, if you feel you have found a growth stock that can make you a fortune, make sure you evaluate its financial statements and growth fundamentals using Mohanram G-Score. In this article, you'll learn everything you need to know.
In this article
What Is The Mohanram G-Score?
The Mohanram G-Score is a financial indicator designed by the accounting professor Partha Mohanram. It consists of nine criteria to evaluate growth (high P/B ratio) stocks and separate the winners from the losers based on financial statements analysis.
In his 2000 paper, he shows how investors can use the score to develop a simple growth investing strategy, such as buying high P/B ratio stocks with a high G-Score and hence strong growth fundamentals.
According to his study, the best growth stocks have a G-Score greater than six (6) and tend to beat the market, while those with a score lower than one (1) tend to have negative absolute returns.
Mohanram G-Score Backtest And Performance
Prof. Mohanram grouped stocks with a G-Score lower than one (1) into the low group and those with a G-Score greater than six (6) into the high group and analyzed their performance in the backtest period between 1979 and 1999.
The mean raw returns for the low group are -4%, as opposed to 17.4% for the high group: a difference of 21.4%. Investors can also observe the significant differences between the groups in the proportion of firms with positive returns (60% for high vs. 34.4% for low).
Source: Prof. Mohanram Paper
How To Calculate the Mohanram G-Score: Formula Explained
The calculation of the Mohanram G-score is very simple—you have to assign one point to the company for each criterion met. Next, you have to add up all the points to get the G-Score:
G1. Return On Assets (ROA) > ROA Industry Median (+1)
G2. Cash ROA > Cash ROA Industry Median (+1)
G3. CFO > Net Income (+1)
G4. Earnings Variability < Earnings Variability Industry Median (+1)
G5. Sales Growth Variability < Sales Growth Variability Industry Median (+1)
G6. R&D Intensity > Industry Median R&D Intensity (+1)
G7. CAPEX Intensity > Industry Median CAPEX Intensity (+1)
G8. Advertising Expenditure Intensity > Industry Median Advertising Expenditure Intensity (+1)
Let's break down each formula's component:
- Return On Assets (ROA) is a measure of how efficiently a company uses its asset base to generate profits. It is equal to net income divided by average total assets. (Learn More)
- Cash ROA is a measure of how efficiently a company uses its asset base to generate cash. It is equal to cash flow from operations by average total assets. (Learn More)
- Earnings Variability is measured as the variance of a firm's ROA in the past five (5) years. As Prof. Mohanram explains in the paper, "for low BM stocks, stability of earnings may help distinguish between firms with solid prospects and firms that are overvalued because of hype or glamour."
- Sales Growth Variability is measured as the 5-year variance in sales growth. As Prof. Mohanram explains in the paper, "a firm that has stable growth is less likely to have had a lucky high realization, and therefore less likely to disappoint in terms of future growth."
- R&D, CAPEX, Advertising Intensity are calculated by dividing each expense by a firm's beginning assets. As Prof. Mohanram explains in the paper, these expenses "may depress current earnings and book values, but may boost future growth and make the firms more likely to meet the market's lofty expectations. Further, conservatism in accounting standards makes firms expense outlays such as R&D and advertising, even if these items create intangible assets. These unrecorded intangible assets depress book values, making it more likely that a firm has a low BM ratio for accounting reasons as opposed to over-valuation."