Monetary Assertion Evaluation for Worth Investing. 2025. Stephen Penman and Peter Pope. Columbia College Press.
The self-discipline of worth investing has had a tricky time of late. The relentless ascent of passive funding methods, the extended outperformance of progress shares for the reason that International Monetary Disaster, and the hovering general valuations in developed markets (the place time-tested valuation ideas not appear to use), to call however a couple of, have all contributed to its struggles. Consequently, the heirs of the Graham and Dodd custom are numbered nowadays and relegated to deep-value methods in rising markets — or Japan. Is that this merely a brief aberration, or does the custom want some refinements to stay related in at the moment’s monetary panorama?
In opposition to this backdrop, Stephen Penman, the George O. Could Professor Emeritus at Columbia Enterprise Faculty, and Peter Pope, Professor Emeritus of Accounting on the London Faculty 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 e-book additionally expands on the framework developed by Penman in his 2011 work, Accounting for Worth.
In each books, readers will encounter traditional worth investing ideas, comparable to negotiating with Mr. Market or the significance of a margin of security, and a few insights from fashionable portfolio idea, such because the neutrality of dividends or an organization’s capital construction in creating worth for shareholders. Practitioners will discover this shocking and eclectic mixture of concepts refreshing and enlightening. Because the authors succinctly state within the introduction:
You’ll discover the e-book contrasts with many funding books. The ever-present beta is just not of highest precedence by far. The widespread discounted money move (DCF) is put apart. Certainly, the e-book is skeptical about valuation fashions typically. Maybe surprisingly, the e-book takes the place that it’s best to assume that “intrinsic worth” doesn’t exist. For a worth investor that seems like heresy, however intrinsic worth is simply too arduous to pin down. That requires another strategy to be placed on the desk, one which challenges the market worth with confidence. Some traders see the choice as buying and selling on multiples, good beta investing, issue investing, and extra. The e-book brings a critique to those schemes.
So, what do the authors suggest? The cornerstone of the e-book is the residual revenue mannequin. First formalized within the Nineteen Eighties[1] and Nineteen Nineties[2], a lot later than different valuation frameworks such because the dividend low cost mannequin, the residual revenue mannequin was popularized within the Nineteen Nineties by the consulting agency Stern Stewart and briefly adopted by the administration groups of a number of giant U.S. firms to gauge whether or not their funding selections had been creating worth for his or her shareholders. Nonetheless, regardless of quite a few educational papers on the mannequin, its adoption by practitioners has remained restricted, lagging behind extra extensively 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 means of the lens of the long run residual (or financial) earnings {that a} enterprise is anticipated to generate. Residual earnings are merely accounting earnings after making an allowance for a price of capital cost. These future residual earnings should then be discounted again to the current and added to the corporate’s present e-book worth to reach at a valuation for the fairness. Notably, if an organization’s return on fairness matches its value of capital, it’ll generate accounting earnings however no residual earnings, which means that its shares ought to commerce at e-book worth. The class 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 revenue) are mathematically equal, the residual revenue stands out for its potential to seize the true sources of worth creation for shareholders. Corporations that don’t pay dividends or reinvest in worthwhile progress alternatives could be arduous to worth utilizing the dividend low cost or the free money move mannequin, respectivel, however they don’t impede the residual revenue framework.
The explanation this mannequin captures worth creation extra precisely (and earlier) is rooted within the accruals that govern present accounting programs. Whereas so-called “money accounting” is commonly favored by practitioners over accrual accounting on the oft-touted premise that money is nearer to “arduous 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 may 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 probably the most distinguished instance. However most significantly, earnings are often acknowledged sooner than money flows below the “realization precept.” As an illustration, gross sales on credit score are acknowledged earlier than the corporate will get the money, capital investments are depreciated over time (rising 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 a long time later. The necessary implication for traders valuing shares in the true 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 belief precept inherently displays sound fascinated about how corporations create worth for traders, in addition to some tips for understanding threat and return. Worth is capitalized on the stability sheet solely when the understanding of the funding is excessive, and subsequent earnings are added to e-book worth solely when they’re realized. From this standpoint, different types of “carrying” the accounting e-book, comparable to truthful worth accounting, fail to uphold these ideas. All through the e-book, Penman and Pope criticize truthful worth accounting for encouraging speculative conduct by inserting unsure values on the stability sheet, which finally contributes to investor hypothesis — as was exemplified through the dotcom bubble.
The e-book devotes many chapters to refining the standard residual revenue mannequin, which, as a result of its reliance on fairness metrics comparable to e-book worth, internet revenue, and return on fairness, fails to adequately deal with the problem of monetary leverage. The purpose right here is that one would possibly assume that including leverage would mechanistically create worth for shareholders since greater leverage would enhance residual earnings by rising the return on fairness.
As Penman and Pope clarify, nonetheless, this line of reasoning is flawed, as the rise in leverage will improve the danger of the funding and, thus, the low cost charges, leaving the valuation unaffected. To resolve this, the authors introduce the residual working revenue mannequin, which makes use of enterprise worth metrics, e.g., internet working property as an alternative of shareholders’ fairness, internet working revenue as an alternative of internet revenue, 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 e-book leaves some house for the “progress 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 method to understanding the problems at stake right here. Penman and Pope argue that simplistic and infrequently deceptive labels comparable to “progress” or “worth” fall brief in advancing the dialog and can’t exchange a radical understanding of accounting ideas.
In conclusion, practitioners will discover Penman and Pope’s e-book not solely extremely related but in addition brimming with invaluable insights. What units this work aside from numerous different “investing” manuals is its bold intention: to supply a collection of disconnected anecdotes and a cohesive and different framework for difficult market costs. The authors skillfully intertwine theoretical depth with considerable real-world examples, reinforcing the reader’s hard-earned intuitions. I’ve little question that this e-book will change into an everlasting traditional within the Graham–Dodd custom and maybe the Holy Grail for future generations of clever traders.
[1] See, as an illustration, 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,” Modern Accounting Analysis 11, no. 2 (1995): 661–687.
[3] S. Penman and F. Reggiani, “Fundamentals of Worth versus Development Investing and an Clarification for the Worth Lure,” Monetary Analysts Journal 74, no. 4 (2018): 103-119.
