Accounting for Value
By Stephen Penman
This week, I am reviewing Accounting for Value. This is an ongoing process, so send me your feedback as to how I can provide you with more value in reviewing these books (send me an email here or leave a comment below). See below to learn how you can win this book!
Stephen Penman is a Professor of Accounting at the Columbia Business School. In Accounting for Value, he teaches the reader about the role of accounting in company valuation. Penman takes on the Herculean (Sisyphean?) task of synthesizing the teachings of Graham and other ‘fundamentalists’ with the principles of modern financial theory, creating a valuation methodology anchored on what is (or at least can be) known with accuracy.
Accounting for Value proceeds as follows:
Chapter 1 reviews the basic fundamentalist approach to company valuation, as taught by Benjamin Graham and then compares it to modern finance. In so doing, he gives a sweeping overview of the history of finance over the last century, providing insight into the different approaches to valuation in practice today. Penman provides ten foundational principles of fundamentalist valuation which he references throughout the book, so I suggest you not skim this chapter!
Chapters 2 and 3 are really the heart of the book – the methodology for accounting for value. Penman explains that a good accounting for value process begins with what is known with accuracy – book value – and separates out the speculative component of the share price. Chapter 2 gives us the tools for accounting for value, but it is Chapter 3 where Penman applies his valuation approach to challenge Mr. Market’s share price. He dissects the speculative component in order to determine what growth expectations are implied by the market price.
Author: Stephen Penman
Chapter 4 and 5 take a deeper look at growth, ensuring that the investor pays only for growth of residual income, rather than earnings, asset or sales growth. Penman adopts the value investor’s fear of leverage, suggesting that, while leverage may increase earnings growth and profitability (which skew the valuation models employed by others), it will not lead to a higher valuation given his model, which would increase the discount rate due to the company’s increased risk.
Chapters 6 and 7 evaluate risk. Penman discards CAPM and similar models which are based on expectations rather than concrete observables. Rather than coming up with a discount rate, he instead compares his equation to the current market price to determine what the market is implying the discount rate to be. The investor is then left to compare this discount rate to the investor’s hurdle rate given what the investor knows about the fundamentals of the company. This approach effectively forces the investor to confront the discount rate head on, rather than blindly following the result of an equation.
Chapters 8 and 9 are a discourse on fair value (market to market) versus GAAP accounting.
Finally, Penman summarizes his approach in Chapter 10 reminding the reader of the different principles and how they all fit together into one theoretically cohesive approach to valuation.
Penman presents his arguments in a clear and logical manner that makes it easy to see how everything fits together. Rather than immediately dispelling any notion of modern finance, Penman embraces the conflict to show how his method both stands true to fundamental investing and satisfies the core takeaways of academic theory. This book was excellent and I recommend it for anyone who completes their own valuations (which I hope includes most of the readers of this site!).
Buy This Book Here or Win This Book!
As I have done with the last few book reviews, I will be using this book as an award for the best investment idea sent to me during the next month. Email me your investment ideas here.
Note: In assessing the quality of your investment idea, I will be looking at how it fits with the investment philosophy I espouse on this site and the strength of the supporting arguments (which can include excel models) as well as the identification of potential pitfalls. I hope that all of those who submit ideas will get some value out of the ensuing discussions. Good Luck!!
Author Disclosure: This book was provided for review by the publisher.
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