Monetary Assertion Evaluation for Worth Investing. 2025. Stephen Penman and Peter Pope. Columbia College Press.
The self-discipline of worth investing has had a troublesome time of late. The relentless ascent of passive funding methods, the extended outperformance of development shares for the reason that International Monetary Disaster, and the hovering general valuations in developed markets (the place time-tested valuation rules now not appear to use), to call however just a few, have all contributed to its struggles. Because of this, the heirs of the Graham and Dodd custom are numbered as of late and relegated to deep-value methods in rising markets — or Japan. Is that this merely a short lived aberration, or does the custom want some refinements to stay related in right this moment’s monetary panorama?
In opposition to this backdrop, Stephen Penman, the George O. Might Professor Emeritus at Columbia Enterprise College, and Peter Pope, Professor Emeritus of Accounting on the London College of Economics, have revealed a 432-page tome entitled Monetary Assertion Evaluation for Worth Investing, a piece firmly rooted within the Graham and Dodd worth investing custom. The guide additionally expands on the framework developed by Penman in his 2011 work, Accounting for Worth.
In each books, readers will encounter basic worth investing ideas, comparable to negotiating with Mr. Market or the significance of a margin of security, and a few insights from fashionable portfolio concept, such because the neutrality of dividends or an organization’s capital construction in creating worth for shareholders. Practitioners will discover this stunning and eclectic mixture of concepts refreshing and enlightening. Because the authors succinctly state within the introduction:
You will see that the guide contrasts with many funding books. The ever-present beta shouldn’t be of highest precedence by far. The widespread discounted money move (DCF) is put apart. Certainly, the guide is skeptical about valuation fashions on the whole. Maybe surprisingly, the guide takes the place that it’s best to suppose that “intrinsic worth” doesn’t exist. For a price investor that seems like heresy, however intrinsic worth is simply too laborious to pin down. That requires an alternate method to be placed on the desk, one which challenges the market worth with confidence. Some buyers see the choice as buying and selling on multiples, sensible beta investing, issue investing, and extra. The guide brings a critique to those schemes.
So, what do the authors suggest? The cornerstone of the guide is the residual earnings mannequin. First formalized within the Eighties[1] and Nineteen Nineties[2], a lot later than different valuation frameworks such because the dividend low cost mannequin, the residual earnings mannequin was popularized within the Nineteen Nineties by the consulting agency Stern Stewart and briefly adopted by the administration groups of a number of massive U.S. firms to gauge whether or not their funding choices have been creating worth for his or her shareholders. Nonetheless, regardless of quite a few tutorial papers on the mannequin, its adoption by practitioners has remained restricted, lagging behind extra broadly used approaches comparable to valuation multiples and the free money move mannequin.
As a fast refresher, the residual earnings mannequin instructs us to consider valuation by the lens of the long run residual (or financial) earnings {that a} enterprise is anticipated to generate. Residual earnings are merely accounting earnings after taking into consideration a value of capital cost. These future residual earnings should then be discounted again to the current and added to the corporate’s present guide worth to reach at a valuation for the fairness. Notably, if an organization’s return on fairness matches its price of capital, it should generate accounting earnings however no residual earnings, that means that its shares ought to commerce at guide worth. The magnificence of the mannequin lies within the seamless integration of enterprise fundamentals with accounting figures, which in flip produce a valuation for the investor.
Though the three valuation frameworks (dividends, free money flows, and residual earnings) are mathematically equal, the residual earnings stands out for its capability to seize the true sources of worth creation for shareholders. Firms that don’t pay dividends or reinvest in worthwhile development alternatives can be laborious to worth utilizing the dividend low cost or the free money move mannequin, respectivel, however they don’t hinder the residual earnings framework.
The rationale this mannequin captures worth creation extra precisely (and earlier) is rooted within the accruals that govern present accounting methods. Whereas so-called “money accounting” is usually favored by practitioners over accrual accounting on the oft-touted premise that money is nearer to “laborious and chilly info” whereas unscrupulous administration groups can simply manipulate accruals, Penman and Pope present that this standard knowledge is just misguided. First, money flows themselves will also be manipulated by administration groups.
Second, there are a plethora of transactions that don’t contain money flows but nonetheless shift worth between stakeholders, with inventory compensation being most likely essentially the most outstanding instance. However most significantly, earnings are often acknowledged sooner than money flows underneath the “realization precept.” For example, gross sales on credit score are acknowledged earlier than the corporate will get the money, capital investments are depreciated over time (growing earnings on the onset of the funding), and pension obligations are accounted for instantly, regardless that money won’t move out of the corporate to pay the guarantees till many years later. The vital implication for buyers valuing shares in the actual world, the place the long run is unsure, is that “[w]ith this earlier recognition of worth added, there’s much less weight on a terminal worth in a valuation.”
In abstract, an accounting system primarily based on accruals and the conclusion precept inherently displays sound fascinated by how corporations create worth for buyers, in addition to some pointers for understanding danger and return. Worth is capitalized on the steadiness sheet solely when the understanding of the funding is excessive, and subsequent earnings are added to guide worth solely when they’re realized. From this standpoint, different types of “carrying” the accounting guide, comparable to truthful worth accounting, fail to uphold these rules. All through the guide, Penman and Pope criticize truthful worth accounting for encouraging speculative habits by putting unsure values on the steadiness sheet, which finally contributes to investor hypothesis — as was exemplified in the course of the dotcom bubble.
The guide devotes many chapters to refining the standard residual earnings mannequin, which, on account of its reliance on fairness metrics comparable to guide worth, web earnings, and return on fairness, fails to adequately tackle the problem of monetary leverage. The purpose right here is that one would possibly suppose that including leverage would mechanistically create worth for shareholders since greater leverage would enhance residual earnings by growing the return on fairness.
As Penman and Pope clarify, nonetheless, this line of reasoning is flawed, as the rise in leverage will enhance the danger of the funding and, thus, the low cost charges, leaving the valuation unaffected. To resolve this, the authors introduce the residual working earnings mannequin, which makes use of enterprise worth metrics, e.g., web working belongings as a substitute of shareholders’ fairness, web working earnings as a substitute of web earnings, and so forth. In doing so, this mannequin redirects the investor’s consideration to the true supply of worth creation in any firm: the operations of the enterprise.
Lastly, the guide leaves some area for the “development versus worth” debate, a subject Penman himself explored in a 2018 Monetary Analysts Journal paper[3], in addition to the connection between agency measurement and fairness returns. Readers will discover {that a} coherent accounting framework and its implications for a way valuation multiples work go an extended strategy to understanding the problems at stake right here. Penman and Pope argue that simplistic and infrequently deceptive labels comparable to “development” or “worth” fall quick in advancing the dialog and can’t change a radical understanding of accounting rules.
In conclusion, practitioners will discover Penman and Pope’s guide not solely extremely related but in addition brimming with invaluable insights. What units this work other than numerous different “investing” manuals is its formidable goal: to supply a collection of disconnected anecdotes and a cohesive and different framework for difficult market costs. The authors skillfully intertwine theoretical depth with ample real-world examples, reinforcing the reader’s hard-earned intuitions. I’ve little doubt that this guide will develop into a permanent basic within the Graham–Dodd custom and maybe the Holy Grail for future generations of clever buyers.
[1] See, as an example, Ok. Peasnell, “Some Formal Connections Between Financial Values and Yields and Accounting Numbers,” Journal of Enterprise Finance and Accounting 9, no. 3 (1982): 361–381.
[2] J. Ohlson, “Earnings, E book Values, and Dividends in Fairness Valuation,” Up to date Accounting Analysis 11, no. 2 (1995): 661–687.
[3] S. Penman and F. Reggiani, “Fundamentals of Worth versus Development Investing and an Rationalization for the Worth Entice,” Monetary Analysts Journal 74, no. 4 (2018): 103-119.
