My Interview with Stephen Penman: Professor of Accounting at the Columbia Business School

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My Interview with Stephen Penman: Professor of Accounting at the Columbia Business SchoolThe markets are going crazy again, I already commented on it and want to move on and ignore the noise. You can see my previous article at the following link-, although I will be commenting from time to time on macro events, I tend to not write any more on the market crash unless the market falls considerably more.

I thought readers would be interested in the following:

I did a recent interview with Stephen Penman; first short bio: Stephen Penman is the 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.

Stephen also wrote a great guest post earlier on Value Walk link here- Benjamin Graham’s Accountant. I also wrote a book review on Accounting for Value here-Accounting for Value by Stephen Pennman.

Below are some highlights from the interview, where we discussed accounting issues at length:

You are not a fan of using cost-of-capita, however, it is one of the most commonly used methods even many value investors. What is your reasoning?

The cost of capital?the required return?is an important concept for the investor: What return do I require to compensate me for taking on risk? My beef is not with the concept, but the means used to measure it. Under the CAPM, one estimates a beta (with considerable error) then multiplies it by the “market risk premium.” The latter is anyone’s guess; estimates of this number in text books runs from 3 percent to 10 percent! (Fancier asset pricing models compound the problem.) The fundamental investor must be honest in investing and, honestly, we don’t know the cost of capital! Guessing at it builds speculation into a valuation.

Much of Accounting for Value is concerned with finessing the problem: Employ the accounting to ask what is the expected return from buying at the current market price, and then ask yourself if that return is sufficient for you, given you have carried out an accounting analysis of risk. We can understand the risk in a business but thinking we can compress this understanding into one number called the cost of capital is a fiction. I see our failure to get hold of the cost of capital as the most disappointing aspect of modern finance?not that we haven’t tried.

You also dislike using discounted cash flow.

I am not a fan of DCF valuation. It discounts free cash flow with that elusive discount rate, but the problem is worse. Free cash flow is not a measure of value added; it is not appropriate accounting for value. That’s easily seen. Free cash flow is cash from operations minus cash investment, so investment reduces free cash flow and liquidation increases free cash flow. That’s perverse. I can show you a number of very profitable firms that have negative free cash flows?because they invest a lot to take advantage of their profitable opportunities. DCF works for long forecasting horizons, but that leaves you speculating about the long-term, or guessing at the “long-term growth rate.” Plugging in an assumed growth rate into a DCF model is dangerous; it results in a speculative valuation that rides on a (speculative) growth rate.

What is the importance of the current market price and how is it more suited to predict the profitability and risk of investment?

I, like most value investors, see price as something to challenge. Price is what you pay, value is what you get. An important risk in investing is the risk to paying too much. So Accounting for Value sets you up to challenge the market price. One sees the market price as information, but information about what other investors are thinking. Understand the earnings forecasts implicit in the market price. Then challenge those forecasts with some good analysis.

To read the full interview click on the following link-–columbia-business-school-accounting-prof-author-of-accounting-for-value

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