Accounting for Value

Accounting for Value

STEPHEN PENMAN
Copyright Date: 2011
Pages: 264
https://www.jstor.org/stable/10.7312/penm15118
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  • Book Info
    Accounting for Value
    Book Description:

    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.

    eISBN: 978-0-231-52185-7
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Introduction
    (pp. vii-xx)
  4. CHAPTER ONE Return to Fundamentals (and an Accounting for the History of Investment Ideas)
    (pp. 1-34)

    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...

  5. CHAPTER TWO Anchoring on Fundamentals (and How Accounting Supplies the Anchor)
    (pp. 35-63)

    THIS CHAPTER SHOWS HOW accounting works in a way that upholds the fundamentalist principles of the last chapter and, in so doing, supplies the anchor that the investor seeks to challenge speculation in market prices. The chapter also shows how the appropriate accounting incorporates those principles of modern finance that we decided to hang onto in the last chapter. The next chapter then goes active to show how one employs accounting to challenge market prices.

    The last chapter surely left you with the impression that developing robust products from ideas in economics and other social sciences is exceedingly difficult. Even...

  6. CHAPTER THREE Challenging Market Prices with Fundamentals (and Deploying Accounting for the Challenge)
    (pp. 64-81)

    THE LAST CHAPTER EXPLAINED that accounting and valuation tie together to such an extent that one can think of valuation as a matter of accounting. But the chapter also showed that accounting for value is typically incomplete, and agreeably so; good accounting minimizes speculation so that one can deploy the accounting to challenge speculation in the market price. This chapter makes the challenge.

    There are a few points to appreciate before I begin.

    Discard the Idea of “Intrinsic Value.” Even though valuation models specify a number, “value,” as the output of the valuation process, it is not helpful to think...

  7. CHAPTER FOUR Accounting for Growth from Leverage (and Protection from Paying Too Much for Growth)
    (pp. 82-103)

    CHALLENGING THE MARKET’S GROWTH forecasts, as in the last chapter, requires an understanding of where growth comes from, that is, what drives growth. The standard view is that growth comes from durable competitive advantage, technological innovation, investment opportunities, and, not least, entrepreneurial insight. These are worthy ideas but they are “soft” concepts, very much in the eye of the speculator. They can, of course, be backed up by evidence of growth in the past, but engaging soft ideas is not entirely satisfactory as a check on speculation. This chapter and the next explain how we can be more disciplined, more...

  8. CHAPTER FIVE Accounting for Growth in the Business (and More Protection from Paying Too Much for Growth)
    (pp. 104-127)

    HAVING ADOPTED UNLEVERED ACCOUNTING, the investor can focus where it matters—on the business where the firm adds value. Businesses promise growth and the market prices growth, but the investor is wary. He or she seeks an accounting for growth that, like accounting for leverage, provides protection from paying too much for growth.

    The previous chapter helps, for it identifies residual earnings growth rather than earnings growth as the measure of value added. One is thus protected from buying earnings growth that does not add value. That chapter also shifts the focus to residual income from business operations rather than...

  9. CHAPTER SIX Accounting for Risk and Return (and a Remedy for Ignorance About the Cost-of-Capital)
    (pp. 128-146)

    THE VALUATIONS TO THIS point have one startling omission. They have been devoted to the question of how to account for payoffs, the numerator in a valuation model, but have been silent about how to measure the required return, the denominator that discounts the expected payoffs for risk. This chapter comes to grips with the problem and, in so doing, also handles the issue of paying for risky growth, left dangling at the end of the last chapter.

    First a reminder: A valuation model is a way to think about valuation, not necessarily a direct prescription for how to do...

  10. CHAPTER SEVEN Pricing Growth (and a Revision to Value Versus Growth Investing)
    (pp. 147-165)

    THE FUNDAMENTALIST UNDERSTANDS that growth is risky. But that is not the view of modern finance, nor indeed among many investment professionals. “Growth” is viewed as yielding lower average returns than “value.” The investor may attribute this to market inefficiency; growth stocks tend to be overpriced. But, for those embracing market efficiency, the lower return must mean that growth is low risk. Extensive academic research has been devoted to explaining the “value- growth spread” as reward for risk.

    Fundamentalists are perplexed. They might attribute these returns to market mispricing, but to see them as returns for risk, with growth being...

  11. CHAPTER EIGHT Fair Value Accounting and Accounting for Value
    (pp. 166-188)

    THIS BOOK BUILDS ON the idea that valuation, at the heart of it, is a matter of accounting. However, I have not yet dealt with the form of the appropriate accounting. Examples to this point have employed GAAP accounting, but GAAP has been extensively criticized in many quarters, not least by equity analysts. Is GAAP appropriate accounting for value? Is GAAP accounting something to anchor on? If not, what is the alternative? This and the next chapter deal with these questions.

    These questions are timely, for both the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are...

  12. CHAPTER NINE Adding Value to Accounting
    (pp. 189-207)

    THE LAST CHAPTER EXPLAINED how historical transactions accounting works for valuation. What remains is to flesh it out. What should historical transaction accounting look like if it is to anchor the investor and challenge speculation? What is the appropriate accounting for valuation? Fear not, I will not bog us down in accounting minutia; the purpose is to paint a picture in broad strokes, outlining core principles rather than a detailed code.

    The humdrum of accounting may not sound very exciting to the investor. The yearly mailings of annual reports are tedious (thank heaven for the paperless world!). You might be...

  13. CHAPTER TEN The Intelligent Investor and the Intelligent Accountant
    (pp. 208-210)

    BENJAMIN GRAHAM SAW INVESTING more as a matter of good thinking than technique, with the fundamentalist principles of Chapter 1 supplying the thinking for his intelligent investor. Accounting for value in this book, based on those same principles, is in the same vein. Although accounting for value lends itself to concrete technique, it is not the technique that is most important. 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...

  14. Notes
    (pp. 211-236)
  15. Index
    (pp. 237-244)