This is a special guest post by Stephen Penman. Stephen Penman is George O. May Professor of Accounting at the Columbia Business School. He is the author of “Financial Statement Analysis and Security Valuation“, for which he received a Wildman Medal Award. He also recently authored a book titled Accounting for Value. The book’s novel approach shows that valuation and accounting are much the same: valuation is actually a matter of accounting for value. Stephen is also an editor of the Review of Accounting Studies.
Value investing delves into “the fundamentals” of a firm. That means knowing a business well, understanding its strategy, its markets, and its management. But often we take the measure of a business through its accounting numbers—its sales, margins, cash flows, its balance sheet position. Indeed we focus on accounting numbers to such an extent that that accounting numbers themselves are often referred to as “the fundamentals.” That is appropriate, for valuation involves quantification—we look for a dollar number—and accounting numbers translate business activities into dollars. Indeed, one can think of valuation as a matter of accounting for value: When one values a firm one is essentially doing an accounting for its value. That is the theme in my recent book, Accounting for Value.
The idea raises two issues. First, how do I actually account for value? How do I get from accounting numbers to a valuation? Second, if I am going to use accounting in valuation, what do I want the accounting to look like? Is it historical cost accounting? Fair value accounting? Is it GAAP accounting?
To answer these questions, let’s stick with the principles that the fundamental investor lives by, from Benjamin Graham on. Price is what you pay, value is what you get. Price is speculative so, to challenge the price, understand what you know and separate what you know from speculation. And importantly, anchor your valuation on what you know rather than speculation. Benjamin Graham saw value as follows:
Value = Minimum true value + Speculative value
“Minimum true value” is a bit vague, but he crystallized the idea somewhat as “value justified by the facts,” value based in what we know, value justified by the fundamentals. Still, these ideas are also vague. That’s where accounting comes in, for accounting is more concrete: What is the value implied by the current balance sheet, sales, earnings, and so on? So we can depict a valuation as
Value = Accounting value + Speculative value
Graham identified speculative value as value coming from growth. He was always apprehensive: Beware of paying too much for speculative growth. In the absence of a clear, durable competitive advantage, growth can easily evaporate. It is easy to imagine that future sales, earnings, and so on will be higher than the present, but anchor your valuation on what you know now and then ask the question: Are there good reasons why the future will be different from the present? Is there growth to pay for?
Accounting value is the no-growth value on which the investor anchors, a value to which one can carefully and conservatively adds value for growth. That calls for a determination of the of the no-growth accounting value, but also for accounting that disciplines our speculation about growth and helps us evaluate how much to pay for it. That is accounting for value.
The details are in Accounting for Value but, briefly, no-growth accounting value is the value in the balance sheet plus added value from earnings in the income statement. With a book value of $8.25 per share and earnings of $1.32 (and thus a return on book value of 16 percent), Cisco Systems has a no-growth accounting value of $14.67 per share. The market price of $16.85 (on April 20) means that the market adds $2.18 for speculation about growth. Using the methods of accounting for value, that translates into a 10 percent EPS growth rate in the future. That’s the market’s forecast: Do I see more growth than this with some margin of safety? If so it is a buy. Do I have difficulty justifying such a growth rate? If so, throw it into the sell basket. I need some further analysis to establish a reasonable growth rate to compare with the market’s implied growth rate, and an accounting for value is completed by supplying an analysis of growth prospects.
But there is another big issue here, the second issue that we referred to earlier. The accounting much be good accounting, something concrete I can anchor on to challenge the speculation in the market price. It must be non-speculative accounting. Benjamin Graham Graham’s accountant would follow his dictum: Tell me what you know?so I can calculate value justified by the facts?and leave the speculation to me, the analyst. Don’t mix what you know with speculation. Give me a “hard” balance sheet on which I can anchor, a balance sheet that cannot come back and hit me later. Give me an income statement that reports sales and margins such that, if conditions are the same in the future, I have a solid forecast of future sales and margins. To this I can add my speculation about growth. Unfortunately GAAP falls short. The trend towards fair value accounting puts speculation in the balance sheet. Worse: it often puts management’s speculation about fair value in the balances sheet. Fair value accounting can come back and hit you, as we recently have seen, to our harm, with Enron and in the recent financial crisis where price bubbles were built into the financial statements. We need a better accounting for value. Benjamin Graham would be looking for a better accountant.
To purchase Stephen’s new book on Amazon.com click on the following link-Accounting for Value (Columbia Business School Publishing)