James Montier C-Score Explained

What Is The Montier C-Score?

The Montier C-Score is a financial indicator designed by James Montier, a member of GMO's Asset Allocation team. It consists of six (6) criteria to evaluate the likelihood a company is manipulating its earnings.

In his 2008 paper, James Montier shows how investors can use the score to separate winners from losers—stocks with high C-scores underperform the market by around 8% p.a. and 5% p.a. in the US and Europe respectively (over the period 1993-2003).

How To Calculate The C-Score: Formula Explained

The calculation of the score is fairly simple—you assign one point to the company for each criterion met. Next, you add up all the points to get the C-Score—from 0 (no evidence of earnings manipulation) to 6 (high probability the company's cooking the book):

1# A Growing Divergence Between Net Income And Cash From Operations

As discussed in the article about the Sloan Ratio, investors pay close attention to reported earnings that drive headlines in the short term. That puts pressure on management to implement any available accounting trick to deliver strong earnings results that may not be sustainable in the long term.

Managements have less flexibility in manipulating cash flows than GAAP earnings, and significant divergence between the two may indicate the company is cooking the books to deliver inflated earnings results.

You can calculate this point as follow:

(CFOfy - NIfy) / ABS(CFOfy) > (CFOfy-1 - NIfy-1) / ABS(CFOfy-1)

2# Days Sales Outstanding (DSO) Is Increasing

As discussed in this article, days sales outstanding (DSO) is the average number of days it takes for a company to collect cash from sales made on credit.

This measure can detect channel stuffing practices, which occur when businesses intentionally send retailers along their distribution channel more inventory than they can sell to boost current quarter’s revenue.

You can calculate this point as follow:

DSOfy > DSOfy-1

3# Growing Days Sales Of Inventory (DSI)

As explained in our prior article, days sales of inventory (DSI), measures the average number of days a company takes to turn its inventory in sales.

As J. Montier explains in his paper, "growing inventory is likely to indicate slowing sales, never a good sign."

You can calculate this point as follow:

DSIfy > DSIfy-1

4# Increasing Other Current Assets To Revenue

Other current assets is a balance sheet section that groups current assets that are unusual or of little importance.

As J. Montier explains in his paper, "canny CFOs may know that investors often look at DSO and/or DSI; thus, they may use this catch-all line item to help hide things they don't want investors to focus upon."

You can calculate this point as follow:

OCAfy > OCAfy-1

5# Declines In D&A Relative To Gross PP&E

Businesses use Depreciation & Amortization to spread the cost of assets over their useful life. For example, if a company buys machinery with a useful life of ten (10) years for $100k and a residual value of $0, it will spread the expense on its income statement over the following ten (10) years.

As J. Montier explains in his paper, "firms can easily alter the estimate of useful asset life to beat the quarterly earnings target."

You can calculate this point as follow:

(D&Afy / Gross PP&Efy) > (D&Afy-1 / Gross PP&Efy-1)

6# Total Asset Growth Greater Than 10%

As J. Montier explains in his paper, "some firms become serial acquirers and use their acquisitions to distort their earnings. High asset growth firms receive a flag in this score."

You can calculate this point as follow:

Total Assets (fy) / Total Asstes (fy-1) > 10%

James Montier C-Score Example Calculation

To illustrate, we can use the formula above to calculate Tesla (NASDAQGS:TSLA) C-Score.

Using the Finbox data explorer, we can find the values of the metrics required to apply the formula:

• Tesla's Net Income to Stockholders (Cont)
  FY: -$862M
  FY-1: -$976M
• Tesla's CFO
  FY: $2.405B
  FY-1: $2.098B
• Tesla's DSO
  FY: 16.9
  FY-1: 12.5
• Tesla's DSI
  FY: 59.3
  FY-1: 56.3
• Tesla's OCA
  FY: $246M
  FY-1: $193M
• Tesla's D&A
  FY: $2.107B
  FY-1: $1.901B
• Tesla's Gross PP&E
  FY: $25.062B
  FY-1: $23.344B
• Tesla's Total Assets
  FY: $34.309B
  FY-1: $29.740B

We can now calculate Tesla James Montier C-Score:

1. Growing Divergence Between NI And OCF — x (0)
2. Increasing Receivable Days — ✓ (+1)
3. Increasing Inventory Days — ✓ (+1)
4. Increasing Other Current Assets — ✓ (+1)
5. Declines In Depreciation Relative To Gross Fixed Assets — x (0)
6. Asset Growth Over 10% — ✓ (+1)

Tesla's Montier C-Score of four (4) indicates that management may be managing earnings but does not meet the full six (6) point criteria.

C-Score Calculator

You can calculate the Montier C-Score for every single public company in the world using this template. You just have to enter the required data of the company whose ratio you want to calculate, and the model will do everything automatically.

You can use the Finbox Data Explorer to get all the data you need for 100,000+ companies worldwide.

Here's a preview of Finbox's Montier C-Score Calculator:

James Montier C-Score Backtest And Performance

In his paper, James Montier divided the entire U.S. stock market into six (6) groups based on C-Score. In the 10-year backtest period between 1993 and 2003, stocks with high C-scores underperform the market by around 8% per year, generating a mere 1.8% CAGR. At the same time, stocks with the lowest C-Score generated a 16% CAGR, beating the market.

Source: James Montier's Paper

Takeaways

The Montier C-Score is a straightforward way of evaluating the likelihood a company is cooking the books to boost its earnings results. Stocks with a high C-Score tend to underperform the market while those with a lower one tend to outperform.