Accrual Ratio

The formula is (Net Income - Free Cash Flow), divided by total assets. When free cash flow is greater than net income, cash earnings are higher than accrual earnings, and the accrual ratio is negative (good).

Richard Sloan from the University of Michigan was first to document what is referred to as the "accrual anomaly". His 1996 paper found that shares of companies with small or negative accruals vastly outperform (+10%) those of companies with large ones. He suggest that investors focus too heavily on earnings and not on cash generation.

They value the earnings of a high accrual company just as highly as the same earnings of a low accrual company, even though the high accrual company's earnings are more likely to reverse in future years. When future earnings reverse, investors are 'surprised' and sell off the stock causing the stock price to decline. Similarly, when a low accrual company's earnings accelerate in future years, they are surprised in a good way. This is measured on a TTM basis and earnings are normalised.