Accounting for Value (Columbia Business School Publishing) [Hardcover]

I have never taken a course in accounting. But I have had to do accounting for most of my working life, including doing financial reporting inside life insurers, which is the most complex industry for accounting. I have even opined on 10+ financial accounting standards over time. And Aleph Blog is a leading accounting website as a user of accounting. (Dubious distinction, I know, but when you are a blogger, you take what you can get. ;) )

As a value investor, I have taken a skeptical view toward the accounting of the companies that I invest in. Cash entries can be trusted; accrual entries are less trustworthy in proportion to the length of time and uncertainty to the collection of cash.

This book relates accounting principles to value investing principles, and it is uncanny as to how they overlap. It also attempts to connect it to Modern Portfolio Theory [MPT] concepts where it makes sense, but with less success. (No surprise, because value investing has a decent theory behind it and MPT doesn't.)

The cornerstone of this book is return on net operating assets [RNOA]. The idea is to split the company in two, and separate operating results from financing results. Give little value to financing results, which are likely no repeatable, and give significant value to operating results.

Note: this means that there is no way of evaluating financial companies under this rubric, but that's a common problem. Financial companies are a bag of accruals; value is difficult to discern. That is why I spend most of my time analyzing the management teams of financial companies to see if they are conservative or not.

The book offers two measures of accounting quality, the Q-score and the S-score. You would have to do more digging to make these practical, but at least you get some direction in the matter.

There are two simple prizes that the book gives to readers:

1) Profit results mean-revert; don't trust strong or weak current ROEs. (or RNOAs)

2) Stocks with low P/Es and P/Bs do well. Each works well, but they work better together. Maybe if Ben Graham were still alive, he would not have been dismissive of his life's work at the end, value works. It's an ugly brain dead strategy, but it works.

Quibbles

None.

Who would benefit from this book: Those who want to improve their perception of investment value would benefit from this book.

It is a very good practical book. Far better than any valuation text book that teaches you theoretical models that yield extremely bad results in real life. The author does a great job at explaining why to do things. It also has thoughtful discussions around value investmenting versus other philosophies, truly getting to the heart of what this investment philosophy is about (much more than buying low price-to-book stocks).

A very good read!

I read this book a year ago and have thought about it since then. It felt like I had missed something important and that I needed to re-read it. I'm happy I did. The Business Professors at Columbia University have done it again. Accounting for Value is another truly interesting valuation book from the center of valuation excellence. But the underlying topic of the book is a bit surprising to an initial doubter. Accounting?

Accounting for value, the Penman way, is far more value added than it sounds. I will still use the Greenwald approach as my base valuation technique. But I have to agree with Penman that most valuation approaches are built on lots of guesstimates. That goes for the Greenwald approach as well, even though there are less of them compared to DCF techniques like Copeland's. The main advantage with Penman's approach is that it separates what we "know" from accounting from speculations about the future. I have started to use "Accounting for value" as a reality check to my "Greenwald Fair Values". For screeners, the Penman approach using accounting data for real valuation calculations is most probably better than simple key ratios like P/E, Price/Book etc.

Like Ben Graham, Penman's focus is to fight the animal spirits of Mr. Market by being careful of paying for more than accounting certainties. His starting base is the level and rate of change in book value of equity. Be really skeptical of paying for growth. Profitable growth is scarce. And never pay for returns created by leverage. Beware of using stock prices in determining fair values. Instead use Mr. Markets pricing to understand expectations. All of Penman's adjustments to true returns and growth are a delight to view.

In addition to the main part of the book - valuation theory based on accounting - there are two topics that are positive spillovers. Penman's review of the advantages (mainly) and disadvantages with cost accounting versus GAAP/IFRS raised my awareness of these issues immensely. We need to debate these issues much more. Mark to market value sounds so obviously right, but can we really trust and handle these sometimes subjective values in the next step from today's financial instruments to tomorrow's inventory or PPE?

The other topic is Penman's introductory discussion on valuation theory (often with recaps from Ben Graham's thinking), the EMH theory and behavioral finance. He blends these topics with a pure elegance seldom seen in a balanced con-clusion where P (price) doesn't necessarily equal V (value). Even James Montier can get intellectual, objective arguments from Penman.

But I don't agree with Penman on two issues. Unlike Penman, I am very doubtful of the Fed Model and its explanatory power. And far more important, I don't fully understand how he decides when a company is genuinely value creating - when returns are above cost of capital (in EVA-terms). To me, this must be based on true values and not on accounting book values. Only then is g (the growth component) a factor to consider in the "valuation formula". I will buy the new edition of his "Financial Statement Analysis and Security Valuation" to find out.

This is one of few books on accounting that is an easy-read. The language is far better than most investing books (although to be honest, there are some repetitions of expressions). A year ago, I would have rated Accounting for Value a 2. Now it gets a 1. Today, I better appreciate Penman's strong argument for his method of prudent accounting valuation. And he also gets some bonus for the best attack - to my knowledge - on the inconsistent way most equity analysts calculate cost of capital (WACC).

This is a review by eqtbooks.com