Accounting for Value teaches investors and analysts howto handle accounting in evaluating equity investments. Accounting for Value. STEPHEN PENMAN. my book summary Accounting for Value teaches investors and analysts how to. Download as PDF, TXT or read online from. Scribd. By Stephen Penman. Accounting for Value teaches investors and analysts how to handle accounting in evaluating equity investments. The book's novel approach shows that.
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Accounting for Value (Columbia Business School Publishing) [Stephen Penman] on medical-site.info *FREE* shipping on qualifying offers. Accounting for Value. Detecting when Price Does not Meet Value. Stephen Penman. Columbia Business School. Columbia University. OIV Conference, Bocconi. However, Penman argues, good accounting is not the one currently new book is Accounting for value (Columbia University Press, ).
Investment analysis—Accounting. P45 This book is printed on paper with recycled content. Neither the author nor Columbia University Press is responsible for URLs that may have expired or changed since the manuscript was prepared. Remember all those accounting jokes?
Or worse: Babel and confusion. Leave it to the nerds, it is not for me. I hope to persuade you otherwise. First understand that, while this book deals with accounting, it is primarily a book on valuation, written for investors and those to whom they trust their savings: The book explains how to employ accounting to estimate share value.
Fundamentalists distinguish price from value—the two can be different—and it is accounting, executed independently of price, to which the investor refers to determine the difference. This book shows how the investor handles accounting to identify value and challenge stock prices. Accordingly, a valuation is only as good as the accounting underlying it. There is thus a question for the accountant to answer: What is good accounting for valuation? The book is a conversation with the investor about valuation, but a conversation that accountants—particularly accounting regulators and standard setters—are most welcome to sit in on.
Like investment advisors, analysts, and portfolio managers, they also serve the investor. The Importance of Accounting If you have ever downloadd a stock, you understand the importance of valuation, but let me persuade you of the importance of accounting.
Indeed we account all the time as a matter of instinctive behavior. We do so in more formal arrangements, but more formally. With corporate accounting, owners keep track of their investments and the stewards who manage them, and with government accounting citizens keep track of their politicians. Without accounting to tell us where we are, where are we?
But of equal importance are accounting systems of high integrity that track our rights and obligations to each other.
Accounting is boring when all is Introduction ix well, but critical when one needs it most. Accounting can be complex— often unnecessarily so—but accounting is no joke. The rubber hits the road with measurement and measurement falls to the accountant.
Accounting forces concreteness, not just concrete numbers but also concrete thinking. What then, one might ask, does the market see? But one cannot, of course, see the future. We, of course, do see factories, employees, the movement of goods and delivery of services, but accounting produces a representation of these realities appropriate for valuation.
This is a gross misconception. Accounting forces managers to face the numbers in reporting to shareholders rather than deliver platitudes about plans and prospects. It forces them to come to grips with reality.
Sound government accounting forces politicians to be straightforward in reporting x Introduction to taxpayers—to view borrowing as debt rather than revenue, for example. It forces reality. And sound accounting for valuation forces investors to come to terms with reality rather than speculate. That opens the question: What is sound accounting for the purpose at hand? Accounting expresses our reality for another reason. One should always be skeptical of any accounting measure, but the demand for summary numbers from the limited information processors of the planet is strong.
But again, the question is: What is a good summary number for the purpose at hand? But this depends on how the accounting is done. Earnings should mean a lot, otherwise the accounting should indeed be dismissed. But computer information consists of many Introduction xi millions of bits and the XBRL taxonomy is a huge array which, in turn, typically aggregates millions of transactions. The user of these technologies—the valuation analyst, for example—is left with the task of handling the information and summarizing what it means.
That process cannot be avoided and that process is accounting.
Disclosure is a cop-out. We simply have too much data these days; data need to be assembled in a compact way. When stocks are priced below the ten year U. Ten year U. Beware of growth from leverage Valuation principle 3 Growth that that is valued does not come from earnings growth but from residual earning growth.
Accounting principle 3 Accounting principle 3a Leverage increases earning growth. Accounting principle 3b Leverage increases profitability the return on common equity. The balance sheet: Standard balance sheet Assets Current assets: Property, Plant and equipment Long term investments Total fixed assets Other assets: Liabilities and Equity Current liabilities: Accounts payable Short term debt Other current liabilities Total current liabilities Long-term liabilities: Long term debt Other non-current liabilities Total long-term liabilities Owner's equity: Capital stock Retained earnings Total owner's equity Total liabilities and owners equity.
Operating assets are those employed in the business like receivables, inventory, and plant. Financial assets are interest bearing assets in which the firm invests to hold excess cash not required for business operations Operating liabilities are not interest bearing liabilities incurred in the course of business, like account payable, deferred revenues, and accrues expenses.
Financial liabilities are interest bearing debt from raising cash to finance the business, like bonds, payable and bank loans Net operating assets are sometimes referred to as net enterprise assets, invested capital, or enterprise book value.
The unleveraged income statement: The unleveraged income statement distinguishes enterprise income net operating income, from the business from the net financing expenses associated with financing activities: It is not necessarily a measure of real business profitability.
Accounting that keeps book values lower generates higher book rates of return and higher residual earnings. Intangible assets patents or copyright and goodwill are booked to the balance sheet if downloadd.
This almost always lower reported profitability, making the acquisition appears unprofitable when in fact it may be otherwise. Accounting for value finesses the problem of not being able to observe real economic profitability. This is because of the way it works: One cannot increase future earnings without decreasing current book value or net operating assets!
Valuation principle 6 Accounting for value produces valuation that correct for the accounting employed; as earnings can be generated by accounting methods only by reducing book value, the appropriate valuation is preserved by employing book value and earnings together. Accounting principle 5 Conservative accounting with investment growth induces growth in residual income.
Uncertainty lies in the future sales growth, in profit margin and asset turnover. These three accounting features connect to the business and they connect the business to residual operating income that measures value added. About cost of capital A valuation model is a way to think about valuation, not necessarily a direct prescription of how to do it.
Beware of plugging in an assumed discount rate, r, the so called cost of capital or required return. After fifty years of research, with Nobel Prizes won, we do not know how to measure the cost of capital! The capital asset pricing model CAMP requires inputs of covariances, betas, and expected market risk premium, all of them expectations in the mind of the beholder rather than concrete observables. Plugging in a CAMP estimate for the cost of capital into the validation formula is simply adding speculation to the valuation.
In theory, asset pricing has it right, ones required return depends on risk and ones price for talking on risk. In CAMP, beta is the risk and the market risk premium is the price of risk. However, ones price of risk is a very personal thing, it depends on ones tolerance for risk, so objective measurements of a risk premium is misdirected individuals feeling about risk and the risk premium might differ significantly.
The fundamentalist approaches the market not with a precise cost of capital in mind to challenge the price, but with a question: What is my expected return to downloading at the current market price? The market price for operations the enterprise price, PNOA is the market price of the equity plus net debt. To answer the question above, one has to reverse engineer the equitation the model to solve for r: Weighted average growth formula [ ] [ ]. But stocks can yield growth, and thus the addition of the second growth term: The weighted average growth formula is just the expected return formula for a bond that does not yield growth adapted for a stock that can yield growth!
Accounting modelling of risk One does not download a stock, one downloads a business, and when downloading a business, know the business.
Accounting for risk models uncertainty as a set of accounting outcomes rather than price outcomes; uncertainty is described as a set of possible financial statements the firm could end up reporting under different scenarios.
Uncertainty is inherent in laying out different scenarios and in forecasting the outcomes in those scenarios. But past business experience guides. In negotiating with Mr. Market on price and his implied growth rate , your advantage lies in understanding the business as a set of alternative path that the business can take.
The modeling of alternative path often produces insights into opportunities or dangers. Accounting principle 6 Under uncertainty, conservative accounting defers the recognition of earnings to the future until the uncertainty has been resolved, and the deferral of earnings results in earnings growth.
Accounting, as practiced for centuries, does not recognize earnings until there has been significant resolution of uncertainty. Misconception about historical cost accounting Traditional historical cost accounting carries assets and liabilities on the balance sheet at their cost. Fair value accounting reports the balance sheet at current values. But value is always in the mind of the holder.
Historical cost accounting does not ignore value added: It updates the balance sheet for value added when the firm trades with customers.
In the parlance of modern finance: Value is not booked to the balance sheet until the firm has a low-beta asset like a receivable or cash from customers.
In contrast, fair value accounting is booking value up font and presents a risky balance sheet If value is missing from book value, it can be plugged with earnings from the income statement.
Thats what residual income valuation does. Accounting principle 7 The stock return is always equal to earnings plus change in the price over book value for the earning period:. Prize minus book value is an error in the balance sheet that fair value accounting and proponents of intangible asset accounting maintain is a failure of accounting.
But accounting principle 7 says that omission of value from the balance sheet does not matter if the error on the balance sheet at the end of the period pricet book valuet is the same as that in the beginning pricet-1 book valuet-1 , the error cancel.
Valuation tolerates accounting error in the balance sheet if that error is constant no growth. More generally: The omission of assets from the balance sheet is mitigated by the income statement and cancelling errors.
In other words, it does not matter if intangible assets are missing from the balance sheet if earnings from those intangible assets are flowing through the income statement! The accounting that includes earnings explains almost all the value that the market sees in the price.
The no growth valuation anchors one for the question of whether value should be added for speculative growth, whether the markets additional value for growth is appropriate. Accounting for value: A balance sheet vs. Earnings are the summary number from the deployment of all assets in the balance sheet jointly. The earning number serves to correct a balance sheet that cannot hope to recognize business value e.
Business is all about entrepreneurial ideas to deploy assets together with people, relationship, and a myriad of other intangibles to get an edge and add value. The intelligent investor and the intelligent account Benjamin Graham saw investing more as a matter of good thinking than technique.
First and foremost, accounting for value supplies a way of intelligently thinking about valuation, it supplies the mental thinking for the intelligent investor. Insights from intelligent investing in turn provide insights into intelligent accounting. The intelligent investor understands that the risk in investing is the risk of paying too much, so seeks to understand the difference between value and price.
The book's novel approach shows that valuation and accounting are much the same: Flag for inappropriate content. Related titles. Rowe Prince, and John Templeton can help you grow rich. Jump to Page. Search inside document.
DCF model: Accrual earnings from business before interest is calculated as Some analysts try to solve the investment problem in DCF valuation by subtracting maintenance capital expenditures from cash flow from operations rather than all investments Buffett called the resulting number owner earnings.
To separate accounting for value from speculative value, one might express the valuation model no growth valuation as: The required return, r, is determined by the risk free rate, rf, and a risk premium, rp: Stocks delivers growth but growth is risky , requiring a higher return, accordingly: