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 because the World Monetary Disaster, and the hovering general valuations in developed markets (the place time-tested valuation ideas now not appear to use), to call however a number of, have all contributed to its struggles. In consequence, 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?
Towards this backdrop, Stephen Penman, the George O. Could Professor Emeritus at Columbia Enterprise College, and Peter Pope, Professor Emeritus of Accounting on the London College 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 ebook 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, corresponding to negotiating with Mr. Market or the significance of a margin of security, and a few insights from fashionable portfolio concept, 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’ll find the ebook contrasts with many funding books. The ever present beta will not be of highest precedence by far. The widespread discounted money movement (DCF) is put apart. Certainly, the ebook is skeptical about valuation fashions basically. Maybe surprisingly, the ebook 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 arduous to pin down. That requires an alternate strategy to be placed on the desk, one which challenges the market value with confidence. Some traders see the choice as buying and selling on multiples, sensible beta investing, issue investing, and extra. The ebook brings a critique to those schemes.
So, what do the authors suggest? The cornerstone of the ebook is the residual earnings mannequin. First formalized within the Eighties[1] and Nineties[2], a lot later than different valuation frameworks such because the dividend low cost mannequin, the residual earnings mannequin was popularized within the 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. Nevertheless, regardless of quite a few educational papers on the mannequin, its adoption by practitioners has remained restricted, lagging behind extra broadly used approaches corresponding to valuation multiples and the free money movement mannequin.
As a fast refresher, the residual earnings mannequin instructs us to consider valuation by the lens of the long run residual (or financial) earnings {that a} enterprise is predicted to generate. Residual earnings are merely accounting earnings after bearing in mind a value of capital cost. These future residual earnings should then be discounted again to the current and added to the corporate’s present ebook worth to reach at a valuation for the fairness. Notably, if an organization’s return on fairness matches its price of capital, it’s going to generate accounting earnings however no residual earnings, that means that its shares ought to commerce at ebook worth. The magnificence 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 capability to seize the true sources of worth creation for shareholders. Firms that don’t pay dividends or reinvest in worthwhile development alternatives could be arduous to worth utilizing the dividend low cost or the free money movement mannequin, respectivel, however they don’t hinder the residual earnings 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 usually favored by practitioners over accrual accounting on the oft-touted premise that money is nearer to “arduous and chilly details” whereas unscrupulous administration groups can simply manipulate accruals, Penman and Pope present that this typical 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.” 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 movement out of the corporate to pay the guarantees till many years later. The vital 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 based mostly on accruals and the belief precept inherently displays sound interested by how corporations create worth for traders, in addition to some tips for understanding threat and return. Worth is capitalized on the steadiness sheet solely when the understanding of the funding is excessive, and subsequent earnings are added to ebook worth solely when they’re realized. From this standpoint, different types of “carrying” the accounting ebook, corresponding to honest worth accounting, fail to uphold these ideas. All through the ebook, Penman and Pope criticize honest worth accounting for encouraging speculative conduct by putting unsure values on the steadiness sheet, which finally contributes to investor hypothesis — as was exemplified throughout the dotcom bubble.
The ebook devotes many chapters to refining the standard residual earnings mannequin, which, as a result of its reliance on fairness metrics corresponding to ebook worth, internet earnings, and return on fairness, fails to adequately tackle the problem of monetary leverage. The purpose right here is that one would possibly suppose that including leverage would mechanistically create worth for shareholders since increased leverage would enhance 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 chance 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 ebook leaves some area 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 approach to understanding the problems at stake right here. Penman and Pope argue that simplistic and infrequently deceptive labels corresponding to “development” or “worth” fall quick in advancing the dialog and can’t change an intensive understanding of accounting ideas.
In conclusion, practitioners will discover Penman and Pope’s ebook not solely extremely related but additionally brimming with invaluable insights. What units this work other than numerous different “investing” manuals is its bold purpose: 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 doubt that this ebook will turn into an everlasting 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,” Up to date 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.
