Explain why earnings revert to the mean and how accruals change how quickly they do so
The idea
Earnings that are far above or below the norm tend to move back towards it, because competition erodes excess profits and poor performers restructure or exit. Analysts should therefore not extrapolate extreme earnings. The speed of mean reversion depends on composition: earnings with a large accrual component revert faster than earnings backed by cash, because accruals reverse and often reflect estimates. The balance sheet accrual ratio is the change in net operating assets divided by average net operating assets. The cash flow accrual ratio is net income minus operating and investing cash flow, divided by average net operating assets. Higher ratios suggest lower persistence. The trap is building a forecast on a record year driven by accruals.
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