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Accounting for Value (Columbia Business School Publishing) Kindle Edition
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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.
Who would benefit from this book: Those who want to improve their perception of investment value would benefit from this book.
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 investingbythebooks.com
I am using this valuation methodology in Indian stock market for last 2 years+ with good outcome. This method is for patient and diligent investor. You will reject 14 out of 15 stocks because they will be flagged, by this method, as overpriced. This is stringent compared to many other valuation methods except may be Graham's Margin of safety valuation where you seek normalized earning yield that is more than twice that of a risk free yield. The result of this restrictive application is you do not overpay at any cost provided you use sensible forecast for next two years and perpetual growth rate equal to GDP growth rate. The beauty of this technology is you do not pay more for mere higher earning growth. it factors in the quality of that earning/profitability. Second, unlike DCF this valuation is anchored firmly in real and verified...book value. Much of the proportion is accounted for by book value while in DCF perpetual growth and valuation take lion's share. I find Penman's method lot more risk averse and grounded in reality.
Excellent book. The only gripe is Penman's writing style. He is not great writer. Although this book is lot more accessible than his textbook. But if you want absolute mastery over financial statement analysis and valuation then I would strongly recommend his textbook also after you read this book first. That book also has many end of chapter problems for deliberate practice. You will be ahead of 99.99% investors if you sincerely study both of his books over 3-4 months.
A very good read!
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