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Jacob Wolinsky
Jacob Wolinsky
Articles  | Author's Website |

Interview Stephen Penman — Columbia Business School Accounting Prof, Author of "Accounting for Value"

August 09, 2011 | About:

Stephen Penman is the George O. May Professor of Accounting at the Columbia Business School. He is the author of “Financial Statement Analysis and Security Valuation“, for which he received a Wildman Medal Award. He also recently authored a book titled "Accounting for Value." The book’s novel approach shows that valuation and accounting are much the same: Valuation is actually a matter of accounting for value. Stephen is also an editor of the Review of Accounting Studies.

Can you tell us a little bit about your background?

I grew up in Queensland, Australia and went to the University of Chicago for my Ph.d. studies. Then followed a wonderful 22 years at the Haas School at Berkeley, moving to Columbia in 1999. With exposure to those three great institutions, I feel truly blessed. The exposure to efficient market theory at Chicago and the Benjamin Graham fundamentalist tradition at Columbia has provided quite a contrast―and prompted some fresh thinking.

Are you involved with the Heilbrunn program at CBS?

Not directly. Of course Bruce Greenwald, Joel Greenblatt, Paul Sonkin and the folks there are good colleagues, but I am primarily involved with the Center for Excellence in Accounting and Security Analysis (CEASA). CEASA has similar interests to the Heilbrunn Center―equity investing―and very much take a fundamental approach, but our focus in on accounting: What sort of accounting does the fundamental investor need? And: How does the investor handle accounting in valuation? These are the themes in my new book, Accounting for Value. What does good accounting look like, and how does the value investor handle bad accounting? GAAP has both.

Can you talk about your first book "Financial Statement Analysis and Security Valuation?"

This is a text book for business school classes on valuation, though I find it is increasingly being read by professionals seeking a deeper treatment of the subject. It is different from the usual “security analysis” text which deals with so-called “asset pricing” that runs students through the Capital asset Pricing Model (CAPM) and beta-bashing (as my students call it). Rather, the book takes as activist approach, seeing the primary risk not as beta but the risk of paying too much for a stock. It marries accounting and finance to address valuation issues. How do I do fundamental analysis? How do I understand value in a business and how do I employ the financial statements―the lens on the business―in doing so? Most importantly, how do I handle information to reduce the risk of paying too much?

How does it differ from your latest book?

You’ll find many of the themes in Accounting for Value in the text book, but with exercises, cases, spreadsheets, and other classroom tools. I will probably bring some of the newer ideas in Accounting for Value in the next edition of the text.

Can you tell us the main theme of your latest book, Accounting for Value?

The title is intriguing (I hope) and provides the main theme: When ones does valuation―to get a number for “value”―one is essentially doing accounting. One accounts for value. A valuation model is an accounting model and so the effectiveness of valuation depends on the accounting. This is easy to see with discounted cash flow (DCF) valuation; that approach uses cash accounting. Is this the accounting (and valuation model) that best serves me in valuation? What is the alternative? An accrual accounting model? If so, what form should this accounting take?

Other themes surface in the book. The fundamentalist dictum that growth is risky is at the fore: Beware of paying too much for growth. The investing scheme focuses on this danger. It shows how to extract the forecast of growth that is implicit in the market price. It then shows how to challenge that growth forecast through further fundamental analysis. Call in negotiating with Mr. Market―Benjamin Graham’s words―using accounting as the language.

Many countries are moving switching to IFRS. There is talk in the US of moving from GAAP to IFRS; which method do you think is better?

IFRS has largely mimicked U.S. GAAP and the two standard setters now work on issues as joint projects. So there really is not much difference between the two. The bigger issue is the shift in both IFRS and GAAP towards fair value accounting. That poses problems for the fundamental investor. Speculative prices―or worse, “fair value” estimates―are brought into the financial statements. By reporting so-called fair values, the financial statements obscure the picture of the value generation in a business. With (speculative) prices in the financial statements, the investor losses an anchor to challenge prices.

For value investors specifically which method do you think is better (which method allows more bargains to be discovered)?

You won’t get an edge from exploiting the fine differences between GAAP and IFRS.

You are not a fan of using cost-of-capita, however, it is one of the most commonly used methods even many value investors. What is your reasoning?

The cost of capital―the required return―is an important concept for the investor: What return do I require to compensate me for taking on risk? My beef is not with the concept, but the means used to measure it. Under the CAPM, one estimates a beta (with considerable error) then multiplies it by the “market risk premium.” The latter is anyone’s guess; estimates of this number in text books runs from 3 percent to 10 percent! (Fancier asset pricing models compound the problem.) The fundamental investor must be honest in investing and, honestly, we don’t know the cost of capital! Guessing at it builds speculation into a valuation.

Much of Accounting for Value is concerned with finessing the problem: Employ the accounting to ask what is the expected return from buying at the current market price, and then ask yourself if that return is sufficient for you, given you have carried out an accounting analysis of risk. We can understand the risk in a business but thinking we can compress this understanding into one number called the cost of capital is a fiction. I see our failure to get hold of the cost of capital as the most disappointing aspect of modern finance―not that we haven’t tried.

You also dislike using discounted cash flow.

I am not a fan of DCF valuation. It discounts free cash flow with that elusive discount rate, but the problem is worse. Free cash flow is not a measure of value added; it is not appropriate accounting for value. That’s easily seen. Free cash flow is cash from operations minus cash investment, so investment reduces free cash flow and liquidation increases free cash flow. That’s perverse. I can show you a number of very profitable firms that have negative free cash flows―because they invest a lot to take advantage of their profitable opportunities. DCF works for long forecasting horizons, but that leaves you speculating about the long-term, or guessing at the “long-term growth rate.” Plugging in an assumed growth rate into a DCF model is dangerous; it results in a speculative valuation that rides on a (speculative) growth rate.

What is the importance of the current market price and how is it more suited to predict the profitability and risk of investment?

I, like most value investors, see price as something to challenge. Price is what you pay, value is what you get. An important risk in investing is the risk to paying too much. So Accounting for Value sets you up to challenge the market price. One sees the market price as information, but information about what other investors are thinking. Understand the earnings forecasts implicit in the market price. Then challenge those forecasts with some good analysis.

Do you believe the book would influence accounting regulators to adopt a more accurate accounting system such as the fair-value accounting system?

Oh, no! I hope the book serves as a check on the progress of fair value accounting. Fair value accounting is appropriate under the right (very limited) conditions, but not as a general rule. “Fair value” sounds good, but misses a point: One employs accounting to help estimate value, but one cannot expect accounting to give you value.

I would hope the regulators take heed of my warnings on fair value accounting, but more importantly on my more positive prescriptions for good accounting. The fundamental investor would then be better served.

Risk is a term that is thrown around a lot in the financial industry. You talk about the different methods of viewing risk in the book, can you elaborate on it?

As I have said, I don’t think the methods of modern finance help us much in getting a handle on risk or in pricing risk. It’s a complex work, full of different and varying uncertainties, so it is too much to expect that the risk in this world can be summarized by an assumed statistical distribution like the normal distribution. Nor can uncertainty be collapsed into on number, the cost of capital.

In my view, it is important to realize that the investor must take some responsibility for assessing and handling risk―you can’t expect the CAPM to bail you out. That involves two things. First, model risk in an accounting framework to understand what you are exposed to. Second, set your own hurdle rate for the risk you see.

On the second point, note that your hurdle rate and mine may be different. In the financial crisis in the fall of 2008, or in July-August of this year when asset prices dropped precipitously, it was said that the fall in prices was partly due to a large revision in the risk premium as investors faced an uncertain world. But individuals’ feelings about risk, and the risk premium they require as the price for risk, might differ significantly. If I am heavily leveraged, my house price is falling, and I am in danger of losing my job in the crisis, my risk premium goes up. I dump risky stocks which, coordinated with others in a similar predicament, forces prices down. Indeed, the drop of stock prices at the time was attributed to people deleveraging and running to the safety of cash. You, on the other hand, have no debt, have sold your house, and have security of employment. Your risk premium is low relative to others, so you see stocks as a bargain. This is your time.

What is the “accounting modeling of risk” as you call it?

What is at risk? Well it’s dividends, but dividends are paid out of book values, so valuation is a question of where the book value will be in 5 or 10 years time. (I am told that is the way Warren Buffett sees it: Where will book value be in 5 or 10 years? Can the firm grow book value?) Correspondingly, risk is the chance of not getting book value. So risk is analyzed by modeling financial statements—balance sheets and income statements―under different scenarios. One can model effects of depression and booms and the effects of those “black swan” tail events not captured by the normal distribution. What is the set of possible balance sheets and income statements I face? After all, its financial reporting that moves stock prices as earnings come down the pike, so model the alternative set of accounting outcomes that will move stock prices. You will then get a feel for how value is at risk.

Besides for behavioral factors, why do investors overpay for growth?

I don’t really know. I suppose one can rationalize anything with a behavioral explanation. Is there a tendency for humans to get too excited about growth, particularly in boom times. Is there a tendency to get too depressed about prospects in bad times? Truly, I don’t know. But I think the basic omission is ignoring information that would be a check on one’s growth expectations. If you don’t check out that information, you are in danger of trading with someone who has more information than you, someone who has done their homework. But an aspect of human behavior must be recognized: We are told that we humans have limited information processing abilities―I sure do. We need a method of compressing and summarizing that information, a rational system that is independent of our behavioral biases. That is accounting. One needs to do some accounting for value to protect against paying too much for growth.

You also discuss leverage and growth, and the danger in it. Some industries by nature are more capital intensive and require more leverage.

The fundamentalist is always careful about taking on leverage, for leverage can turn around and kick you. What people don’t quite realize is that leverage adds to growth. Accounting for Value demonstrates this clearly. Leverage increases earnings-per-share growth which makes the firm look like a good growth prospect. But growth that comes from leverage is dangerous; it can come back and kick you. Beware of paying for growth generated by leverage. It’s different from growth in the business, and should be valued differently.

In the beginning of the book you discuss the history of accounting, can you elaborate and tell us where you think we are nowadays: from the perspective of regulators, Wall Street, and value investors?

In the 1920s, accountants wrote up balance sheets; they put water in the balance sheet, as Benjamin Graham used to say. That water evaporated in 1929 with the crash. In 1933, with the formation of the SEC in reaction to that experience, the notion of conservative accounting became foundational and dominated accounting regulation through to the 1990s. Then the fair value idea took over. Enron was, at the heart of it, a fair value accounting house-of-cards, with approval for the use of fair value accounting actually given by the SEC. Fair value accounting came into banks balance sheets during the real estate financing bubble of 2005-2007 as banks marked mortgage loans to market as so-called “available-to-sale” securities. Bubble prices came into the financial statements. Water in the balance sheet. The fundamentalist loses an anchor. I hope the accounting authorities go no further with this idea.

Thank you for your time.

To purchase Stephen Penman’s new book on Amazon.com, click on the following link- "Accounting for Value." (Columbia Business School Publishing)

Disclosure: I receive free books from book publishers and authors asking me to review them. In addition I sometimes request specific books that look interesting. I try to review the books that I think will be the most interesting. I have a material connection because I received a free copy of this book from the publisher. In addition I receive a small commission if you click on the above link and buy the book (or anything else) from Amazon.com. However, it does not cost you a penny more.

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

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