Accounting for Value

Stephen Penman

• Publisher: Columbia University Press
• Year: 2010
• ISBN:
  9780231521857
• Topic: Commerce
• Subtopic: Comptabilité financière

Accounting for Value teaches investors and analysts how to handle accounting in evaluating equity investments. The book's novel approach shows that valuation and accounting are much the same: valuation is actually a matter of accounting for value.

Laying aside many of the tools of modern finance—the cost-of-capital, the CAPM, and discounted cash flow analysis—Stephen Penman returns to the common-sense principles that have long guided fundamental investing: price is what you pay but value is what you get; the risk in investing is the risk of paying too much; anchor on what you know rather than speculation; and beware of paying too much for speculative growth. Penman puts these ideas in touch with the quantification supplied by accounting, producing practical tools for the intelligent investor.

Accounting for value provides protection from paying too much for a stock and clues the investor in to the likely return from buying growth. Strikingly, the analysis finesses the need to calculate a "cost-of-capital," which often frustrates the application of modern valuation techniques. Accounting for value recasts "value" versus "growth" investing and explains such curiosities as why earnings-to-price and book-to-price ratios predict stock returns. By the end of the book, Penman has the intelligent investor thinking like an intelligent accountant, better equipped to handle the bubbles and crashes of our time. For accounting regulators, Penman also prescribes a formula for intelligent accounting reform, engaging with such controversial issues as fair value accounting.

CHAPTER ONE

Return to Fundamentals (and an Accounting for the History of Investment Ideas)

VALUATION IS A SET of methods for determining the appropriate price to pay for a firm. Accounting is a set of the methods for producing the information for that determination. Both are man-made constructions; they are a matter of design. This book asks: What is an effective design for valuation and how should accounting be designed to support valuation? These, of course, are perennial questions for both analysts and the authorities who lay down accounting standards. The book explains that valuation and accounting are very much the same thing: Valuation is a question of accounting for value. Accordingly, the valuation design question and the accounting design question are resolved in tandem.

As architects and engineers well know, safe and effective design rests on firm underlying principles (of the physical sciences). Otherwise, the house or bridge falls down. This chapter examines the principles on which a valuation architecture and an accounting architecture might be securely built. Architects and engineers also appreciate an overarching principle: The endeavor is utilitarian, the design must serve the users. So let’s first focus on you, the investor, and ask: What are the principles under which you operate? Although the accounting rules of today are influenced by corporate management, investment bankers, bureaucrats, accountants, lawyers, and politicians and their lobbyists—with or without your interest in mind—my focus is on you. You, after all, are the owner of corporations, or seek to become one, and there are many of you.¹ How may you best be served? To answer that question I will review the history of investment ideas, ask how well those ideas serve you, and embrace or replace them as needed to get accounting and valuation on a firm footing.

Let’s suppose you are an investor who is moving money from the safe haven of a money market fund into the stock market. You understand that the stock market is how wealth generated by corporations is shared in a capitalist economy, and you want a part of it; you want to be an owner. But you are apprehensive; you are cautious. You understand that stocks have significant upside potential over a money market fund, but there is also a downside. Witness the devastation to investors’ retirement accounts in recent years. Is the stock market just a casino? You are not a gambler going for the jackpot, for you know that, just as the house on average wins against the gambler, so the agents in the stock market—the brokers, the investment managers, and other middlemen between you and your investments—are keen to take “house money” in the fees they charge you. You are willing to pay appropriate fees, but you want some comfort, some assurance that the game is not against you. You are concerned that you may be playing against professional investors. You can’t protect yourself against inside information (though insider trading laws are on your side here), but you are worried that those on the other side of your stock trades may be doing their homework. So you want to make sure you have an investing approach that protects you, even one that gives you an edge. If you do surrender your money to the care of professionals, you want to be assured that they have an edge.

Now you may be an investor who draws your confidence from faith in your fellow investors. They have far more information than you, you perceive, so you take the price they set as a fair price and buy and sell at that price. You “free-ride” on their efforts to value stocks. You are not concerned that their expertise in valuation puts you at a disadvantage. In the parlance of modern finance, you believe that “efficient markets” yield rational prices that summarize all available information, and this belief is where you get your comfort. There is nothing for you to add by doing additional work. You take the advice to “invest for the long run” for (we are told) stocks reward the investor for the added risk over money market funds “in the long run.” You heed the warning that you take on unnecessary risk if you don’t diversify, so a broad-based market index fund is appropriate for you. (It also has lower fees!) You are a passive investor. If so, this book is not for you, and we wave goodbye with a cordial “best of luck.” You do not need to understand valuation. You do not need accounting. You will not be lonely, for there are many money managers who simply “allocate” investors’ funds to stocks and bonds without much investigation. But remember that, to make the market efficient for you, someone must be doing the accounting and someone must be doing the valuation. And that someone expects to get a reward for his or her labors, possibly by trading with you or your money manager at your expense.

Alternatively, you may be an investor who sees the appeal of the efficient market hypothesis but, with so many assailing the idea these days, you come to the game with some skepticism. On the one hand, you ask yourself: How can a market with many, presumably sophisticated, investors be grossly inefficient? How can prices be so wrong when there are so many keen traders working daily (and even minute by minute) to arbitrage away any obvious profit opportunities? Surely their information gets impounded in prices quite speedily. That, after all, is what economics teaches us about markets, particularly ones like the stock market, where there are few “barriers to entry.” On the other hand, with the skepticism learned from life (some reserved for economists), you take the view to trust but verify. The market may be efficient, but it pays to investigate; one kicks the tires before buying a used car, and one inspects the goods before buying a used stock, for the previous owner might have a reason for off-loading it on you. After all, buying stocks at the high multiples of earnings, book values, and cash flows of the late 1990s was not such a good idea, at least after the fact. Nor was the purchase of stocks at the height of the housing and credit bubble in 2006–2007. You are cautious; Benjamin Graham, the father of fundamental investing would call you a “defensive investor.” This book is for you.

Finally, you may be an investor who comes to the game with the conviction that prices are not rational. You cannot see any good economic explanation for momentum pricing, the tendency for prices to continue to rise or fall. You saw the stock prices of the late 1990s as bubble prices. You saw Cisco Systems trading at well over 100 times earnings as folly. You recognized Dell Computer as a very good firm, but trading at 88 times earnings in 1999 seemed a bit rich. Indeed, with the S&P 500 trading at 33 times earnings against a historical average of 15, you questioned the entire market at the time.² Recalling the Japanese price bubble a decade before and the “Nifty-Fifty” pricing of the 1970s in the United States only reinforces your view.³ Share prices in China today seem crazy. In answer to the seeming economic imperative of efficient market theory, you may have your own pop psychology idea as to why animal spirits—to use Keynes’s term—overtake stock markets. Or you might be a reader of the new “behavioral economics” that attempts to explain in more scientific terms why prices appear irrational: Investors follow the herd, whether optimistic or pessimistic; they follow fashion and pursue “glamour” stocks; overconfidence overrides common sense; humans ignore information or cannot process information adequately; humans overreact to information; humans’ judgments are biased. These attributes bring “noise traders” to the market. You think you can “beat the market” by being a more “rational” human; you can gain by trading at “irrational” prices. You are one of Benjamin Graham’s “active investors.” This book is also for you.

It is clear that you, the investor, are in the middle of the efficient market debate, a debate that has engaged both investors and academics for almost fifty years. The efficient market view of the stock market has dominated modern finance and the academic view of the investing landscape for many years. But the mention of Benjamin Graham reminds us that this was not always the case. The efficient market view, associated with the University of Chicago in the 1960s and 1970s (and Eugene Fama in particular), was a departure from the ideas of the fundamentalists associated with Columbia University in the 1930s and 1940s (and Benjamin Graham in particular). Just as efficient market theory assailed fundamental analysis in the 1960s, the efficient market view has been assailed in recent years in academic debate but also from stark investor experience.

Here we return to fundamentals, to review what was learned then and what can be further learned. We do so in order to think about how we should face the investment task and how we might build the accounting and valuation tools that will aid that task. But we do so with an appreciation of the significant contributions of modern finance to investment theory and practice. Some of the principles of modern finance may need to be rejected, but some may depose fundamentalist principles. We examine fundamentalist principles and the principles of finance in turn, to ask what needs to be discarded and what is to be embraced, and so establish a foundation on which valuation and accounting can be designed.

First, the principles espoused by fundamentalists. These are principles of “sound investing” but are also principles to forge the accounting and valuation methods used in sound investing. Fundamentalists refer to “value justified by the facts.” I hope to show you in subsequent chapters that value justified by the facts is a matter of accounting. That accounting challenges the market price, validates it as “efficient” for the defensive investor (or not), and (if not) provides a tool for the active investor. These investing principles morph into valuation principles and accounting principles in subsequent chapters, and we will hark back to them continually. At this point I mention just a few implications for accounting and valuation—to give a taste of what’s to come.

Fundamental Principles

If you read Graham’s The Intelligent Investor—and one is advised to do so—there is not much in the way of techniques or calculations.⁴ Rather, Graham instructs us how to think about investing. He writes as a sage, he offers wisdom. Investing, he says, is first about attitude and approach rather than technique. Modern finance, as befits modernism, is about technique; formulas and models are at the fore. Just as engineers construct bridges and spacecraft using mathematical equations, so do modern financial engineers, whether it be models of risk and return like the Capital Asset Pricing Model (CAPM), models to price credit default swaps, models to price options (Black-Scholes and the binomial option pricing models), or, closer to home, discounted cash flow models to value equities. These models are part of the remarkable contribution of financial economics over the past fifty years. Yet these same models have been called into question, particularly during the recent financial crisis, so we do well to reconsider the more “soft” principles of yesteryear.

Here are 10 principles distilled from years of practice by fundamentalists. Most of them are familiar. I remind you of them to establish a foundation on which to build an accounting for value. Most are just plain common sense. But it is plain common sense that provides the antidote to the animal spirits against which we are warned, and it is plain common sense that questions the supposed sophistication of a mathematical model.

1. One does not buy a stock, one buys a business

2. When buying a business, know the business

3. Price is what you pay, value is what you get

4. Part of the risk in investing is the risk of paying too much

5. Ignore information at your peril

6. Understand what you know and don’t mix what you know with speculation

7. Anchor a valuation on what you know rather than on speculation

8. Beware of paying too much for growth

9. When calculating value to challenge price, beware of using price in the calculation

10. Return to fundamentals; prices gravitate to fundamentals (but that can take some time)

Let’s consider each principle in turn.

ONE DOES NOT BUY A STOCK, ONE BUYS A BUSINESS. This point reminds us that, when buying stocks, one buys not paper, but claims on a business. Impressive amounts of paper are traded on our exchanges each day, not only equity claims but also corporate debt, not to mention the derivative instruments tied to these claims.⁵ Do these traders trade businesses or do they trade paper? Efficient market investors buy paper, without investigation of the business. Day traders buy paper, or even just a ticker symbol. But fundamental investors buy a business.

WHEN BUYING A BUSINESS, KNOW THE BUSINESS. Equity research reports open with a discussion of the business before they get to the numbers. And so they should, for to value a business one has to understand the business. That amounts to understanding the idea behind the business—the business model—and managements’ execution of the idea. Successful business rides on a good entrepreneurial idea and the translation of that idea into value through business operations. Valuation, in turn, is a matter of translating one’s knowledge of the business model and its execution into a price for the business. That translation is a matter of accounting. One observes factories, mines, farmers’ fields, inventories, customers, suppliers, sales and purchase prices, and the many transactions in which a business engages. What to make of it? Accounting pulls these many features together to make sense out of them for the investor. Accounting, and the financial statements it produces, is the lens on the business, but only if the accounting is done well. The accounting designer seeks to focus the lens.

PRICE IS WHAT YOU PAY, VALUE IS WHAT YOU GET. Unlike the efficient market investor, fundamental investors do not accept price as necessarily equal to value. Price is what the market is asking the buyer to pay, value is what the share is worth. Fundamentalists entertain the notion that prices can “deviate from fundamentals.” So they approach prices skeptically and they challenge prices to understand whether prices are justified by value received. They understand that one buys a business and the business can be a very good business—like Cisco Systems and Dell Computer—but they also know that good businesses can be bad buys—like Cisco and Dell in 1999.

PART OF THE RISK IN INVESTING IS THE RISK OF PAYING TOO MUCH. Modern finance supplies models, like the CAPM, to help us understand the risk of holding a stock. Business school students are drilled on beta, in an exercise they refer to as “beta bashing.” Beta measures the investor’s susceptibility to price movements. The fundamentalist sees it differently. As a matter of first order, the risk is in buying a stock rather than holding it, and that risk is the risk of paying too much. To fundamentalists, knowing a firm’s beta ranks rather low on the list of things they would want to know. They are buying value, so, although they are concerned with fundamental risk—the risk from competition, poor management, and too much debt that can damage value—they are less focused on the price fluctuations that are the concern of those who buy just on price alone. Indeed, they may see a price drop as presenting an opportunity rather than inflicting damage. Buying at less than value is low risk, in fact providing a “margin of safety.”⁶ They emphasize the need for a model to detect the risk of paying too much rather than a beta model.

IGNORE INFORMATION AT YOUR PERIL. Equity investing at its core is a matter of dealing with uncertainty. Information reduces uncertainty, so this principle is indeed pure common sense, to be dismissed only if one is persuaded that efficient prices already contain all the information required. However, the point begs the questions “What information is relevant?” and “How do I pull that information together?” That is a matter of accounting, of accounting for value.

UNDERSTAND WHAT YOU KNOW AND DON’T MIX WHAT YOU KNOW WITH SPECULATION. In evaluating climate change and its effects, the rationalist holds to the adage “Let’s understand what we know—the science—and separate that from fear and speculation.” Only then can one develop persuasive scenarios and design corrective action. The adage also applies to investing: Don’t contaminate what you know—your reliable information—with conjecture. Knowing a firm had sales of $150 million this year is different from a forecast that sales three years hence will be $ 250 million. Don’t mix them. Focus on “value justified by the facts,” and so be better prepared to challenge speculation. If c...