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 total valuations in developed markets (the place time-tested valuation ideas now not appear to use), to call however just a few, have all contributed to its struggles. Consequently, the heirs of the Graham and Dodd custom are numbered lately 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 as we speak’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 printed 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, similar to negotiating with Mr. Market or the significance of a margin of security, and a few insights from trendy portfolio principle, 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 discover the guide contrasts with many funding books. The ever-present beta isn’t of highest precedence by far. The frequent discounted money stream (DCF) is put apart. Certainly, the guide is skeptical about valuation fashions typically. Maybe surprisingly, the guide takes the place that it’s best to suppose that “intrinsic worth” doesn’t exist. For a price investor that appears like heresy, however intrinsic worth is simply too onerous 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, 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 giant U.S. companies 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 broadly used approaches similar to valuation multiples and the free money stream mannequin.
As a fast refresher, the residual earnings mannequin instructs us to consider valuation via the lens of the long run residual (or financial) earnings {that a} enterprise is predicted to generate. Residual earnings are merely accounting earnings after making an allowance for 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 value of capital, it can generate accounting earnings however no residual earnings, which means that its shares ought to commerce at guide 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 earnings) are mathematically equal, the residual earnings stands out for its potential to seize the true sources of worth creation for shareholders. Firms that don’t pay dividends or reinvest in worthwhile development alternatives can be onerous to worth utilizing the dividend low cost or the free money stream 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 “onerous and chilly info” whereas unscrupulous administration groups can simply manipulate accruals, Penman and Pope present that this standard knowledge is solely 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 in all probability probably the most outstanding instance. However most significantly, earnings are often acknowledged sooner than money flows below 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, though money won’t stream out of the corporate to pay the guarantees till many years later. The essential implication for traders valuing shares in the actual world, the place the long run is unsure, is that “[w]ith this earlier recognition of worth added, there may be much less weight on a terminal worth in a valuation.”
In abstract, an accounting system based mostly on accruals and the conclusion precept inherently displays sound enthusiastic about how corporations create worth for traders, in addition to some pointers for understanding danger and return. Worth is capitalized on the stability sheet solely when the knowledge of the funding is excessive, and subsequent earnings are added to guide worth solely when they’re realized. From this standpoint, various types of “carrying” the accounting guide, similar to honest worth accounting, fail to uphold these ideas. All through the guide, Penman and Pope criticize honest worth accounting for encouraging speculative habits by putting unsure values on the stability 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 normal residual earnings mannequin, which, as a consequence of its reliance on fairness metrics similar to guide worth, internet earnings, and return on fairness, fails to adequately handle the difficulty of economic leverage. The purpose right here is that one may suppose that including leverage would mechanistically create worth for shareholders since larger leverage would increase residual earnings by growing the return on fairness.
As Penman and Pope clarify, nevertheless, 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., internet working belongings as an alternative of shareholders’ fairness, internet working earnings as an alternative of internet 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 house 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 dimension and fairness returns. Readers will discover {that a} coherent accounting framework and its implications for a way valuation multiples work go an extended solution to understanding the problems at stake right here. Penman and Pope argue that simplistic and infrequently deceptive labels similar to “development” or “worth” fall brief in advancing the dialog and can’t change a radical understanding of accounting ideas.
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 aside from numerous different “investing” manuals is its formidable purpose: to supply a sequence of disconnected anecdotes and a cohesive and various framework for difficult market costs. The authors skillfully intertwine theoretical depth with plentiful real-world examples, reinforcing the reader’s hard-earned intuitions. I’ve little doubt that this guide will turn into a permanent basic within the Graham–Dodd custom and maybe the Holy Grail for future generations of clever traders.
[1] See, as an example, Okay. 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 Rationalization for the Worth Lure,” Monetary Analysts Journal 74, no. 4 (2018): 103-119.
