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					                                                                                            My Summary

Accounting for value
By Stephen Penman

My Summary

Valuation is a set of methods for determining the appropriate price for a firm.

Accounting is a set of methods for producing the information for that determination.

Investing is about attitude and approach rather than technique (Benjamin Graham).

The 10 (common sense) fundamentalist principles:

    1. One does not buy a stock, one does buy a business.
    2. When buying a business, know the business.
    3. Price is what you pay, value is what you get.
       Price is what the market is asking the buyer to pay; value is what the share is worth.
    4. Part of the risk in investing is the risk of paying too much.
       Buying at less than value is low risk, in fact providing a margin of safety.
    5. Ignore information at your peril.
       The point begs the question “What information is relevant?” and “How do I pull information
       together?” That is a matter of accounting, of accounting for value.
    6. Understand what you know and don’t mix what you know with speculation.
       Focus on value justified by facts… don’t add too much speculation to the financial
    7. Anchor a valuation on what you know rather than on speculation.
       Sort out what you know and apply it to challenge speculation.
               Value = Anchoring accounting value + Speculative value
    8. Beware of paying too much for growth.
       In most case, other than a firm with a clear, protected franchise, growth will be competed
    9. When calculation value to challenge price, beware of using price in the calculation.
       Refer to information that are independent of price; price is not value, so do not refer to price
       in calculating value.
    10. Return to fundamentals; prices gravitate to fundamentals (but that can take some time).
        Be patient! Prices gravitate to fundamentals as information on which value is based is
        recognized by the market.

accounting for value                                                                             page 1
                                                                                                  February 14

Accounting Principle 1

The principle says that earnings add to book value, while dividends reduce book value. Thus, ending
book value for any period is beginning book value plus earnings minus dividends. Think of current
book value and the earnings likely to be added to book value in the future.

                                                           r = discount rate, the required return for risk

Valuation principle 1

To get handle on value, think of what the book value is likely to be in the future.

Valuation principle 2

If one forecasts that rate of return on book value (=ROCE) will be equal to the required rate of return
(=r), the assets must be worth its book value.

                            ROCE = rate of return on book value, book rate of return on common equity

Accrual accounting for value
Cash accounting for value
Free Cash Flow (FCF) is the difference between cash flow from operations and cash from
investments (CAPEX) in operations.

         revenues                                       operating income (EBIT)
       + costs of goods sold (cost of sales)          - taxes
       = grosss profit                                = net operating profits less
                                                        adjusted tax (NOPAT)
       + sales and marketing                          + depreciation and amortization
       + research and development                     = operating cash flow
       + general and administrative                   ± change in working capital*
       + other operating expenses                     - capital expenditure (CAPEX)
       = operating income (EBIT)                      - other expenditures
                                                      = free cash-fow
                                                  *(net) working capital = Current assets – Current liabilities

accounting for value                                                                                   page 2
                                                                                              February 14

The DCF analysis forecasts what will flow through the future cash flow statements. DCF analysis is
accounting for value, but it is cash accounting for value.

DCF model:

                                    FCF = free cash flow, r = discount rate, the required return for risk,

                                                      g = growth rate,

The problem with DCF is an accounting problem: FCF subtracts cash investments (CAPEX) from
operating cash flow. This is odd because investments are made to add value, not reduce it. A firm is
increasing FCF by liquidating investment, it’s not only odd, it’s perverse.

The alternative to cash accounting is accrual accounting.

Accrual accounting for value
Accrual accounting reports earnings rather than cash flows.

Accounting Principle 2

Accrual accounting brings the future forward in time, anticipating future cash flows.

Total earnings and total cash flow are the same over the life of a firm; accrual accounting just
changes the timing: a receivable booked to balance sheet forecasts cash inflows, and the accrued
pension liability forecasts very distant cash outflows.

Accrual accounting is applied as a strait forward correction to cash flows. Accrual earnings from
business (before interest) is calculated as

Some analysts try to solve the investment problem in DCF valuation by subtracting maintenance
capital expenditures from cash flow from operations rather than all investments (Buffett called the
resulting number owner earnings). GAAP (generally accepted accounting principles) subtract a
number called depreciation on existing investments (from earnings) rather than full investment

accounting for value                                                                               page 3
                                                                                               February 14

Adding speculation to book value
One adds value to book value only if the expected rate of return on book value is greater than the
required return (see also valuation principle 2).

                                    r = discount rate, the required rate of return for risk, b = book value
                                       g = growth rate, the rate at which residual earnings are expected
                                                             to grow after year 3 (terminal growth rate)

Residual earnings compare the rate of return on book value (ROCE) with the required return. It is
sometimes referred to as excess earnings or abnormal earnings and is alternatively calculated as
earnings less a charge against book value to cover the investor’s required return (or cost of capital).

Valuation principle 3

To get handle on value, think of what the book value is likely to be in the future, and second, what
rate of return on that book value is likely to be.

To separate accounting for value from speculative value, one might express the valuation model (no
growth valuation) as:

The no growth valuation means that residual earnings are deemed to continue at a constant level
(with no growth) after the forecast horizon.

There are two drivers of residual earnings: book value (b) and the rate of return on book value
(ROCE). A combination of decreasing rate of return on book value (profitability) and increasing book
value results in constant, no growth residual earnings. This is quite typical as firms are challenged by
competition. However, a firm can maintain residual earnings growth with declining profitability by
adding investment that earns at rate of return greater than the required return.

accounting for value                                                                                page 4
                                                                                               February 14

The risky growth benchmark
Growth is risky; added value from growth comes with added risk.

Don’t add growth to a valuation without adding the required return: Adding to the growth rate and
the required return leaves the denominator (r-g) unchanged.

The required return, r, is determined by the risk free rate, rf, and a risk premium, rp :

                                              rf = risk free rate, e.g. risk free government long bond rate
                                                                                          rp = risk premium

Suppose the growth rate, g, purely reflects risk, such as:


…growth and risk premium cancel exactly. Stocks delivers growth but growth is risky , requiring a
higher return, accordingly:

This valuation approach is close to the Fed model, often discussed in the press: The Fed model sees
the benchmark E/P ratio for the stock market as equal to the long term bond rate:

When stocks are priced below the ten year U.S. government bond, they are deemed to be
overpriced; the market is set ting the yield to low. Ten year U.S. government bond of February 2014
= 2.64 (here, or here).

Beware of growth from leverage

Valuation principle 3

Growth that that is valued does not come from earnings growth but from residual earning growth.

Accounting principle 3

Accounting principle 3a
Leverage increases earning growth.

Accounting principle 3b
Leverage increases profitability (the return on common equity).

accounting for value                                                                                page 5
                                                                                            February 14

Valuation principle 5

Valuating principle 5a
Leverage reduces the P/E from the enterprise P/E if the enterprise P/E is less than 1/ borrowing cost.

Valuating principle 5b
Leverage increases the P/B ratio over the enterprise price to book if the enterprise to book I greater
than 1.

The balance sheet:

             Standard balance sheet                    unleveraged balance sheet
             Assets                                    operating assets
             Current assets:                           working cash
             Cash                                      accounts receivable
             Short term Investments                    financing receivables
             Accounts receivable                       inventories
             Inventories                               property, plant, equipment
             Other                                     goodwill
             Total current assets                      intangible assets
                                                       other operating assets
             Fixed assets:                             total operating assets
             Property, Plant and equipment
             Long term investments                     operating liabilities
             Total fixed assets                        accounts payable
                                                       accrued liabilities
             Other assets:                             deferred revenues
             Goodwill                                  other liabilities
             Intangible assets                         total operating liabilities
             Total other assets
                                                       ∆ = total net operating assets
             Total assets

                                                       financial assets
             Liabilities and Equity                    cash equivalents, excessive cash
             Current liabilities:                      short term investments
             Accounts payable                          long term investments
             Short term debt                           total financial assets
             Other current liabilities
             Total current liabilities                 financial liabilities
                                                       short term borrowing
             Long-term liabilities:                    long term debt
             Long term debt                            total financial liabilities
             Other non-current liabilities
             Total long-term liabilities               ∆ = total net financial assets

             Owner's equity:
             Capital stock                             owner’s equity
             Retained earnings                         Capital stock
             Total owner's equity                      Retained earnings
                                                       total owner's equity
             Total liabilities and owner’s equity

accounting for value                                                                             page 6
                                                                                                 February 14

            Operating assets are those employed in the business like receivables, inventory, and plant.
         Financial assets are (interest bearing) assets in which the firm invests to hold excess cash not
                                                                           required for business operations
        Operating liabilities are (not interest bearing) liabilities incurred in the course of business, like
                                              account payable, deferred revenues, and accrues expenses.
   Financial liabilities are (interest bearing) debt from raising cash to finance the business, like bonds,
                                                                                    payable and bank loans
        Net operating assets are sometimes referred to as net enterprise assets, invested capital, or
                                                                                     enterprise book value.

The unleveraged income statement:
The unleveraged income statement distinguishes enterprise income (net operating income, from the
business) from the net financing expenses associated with financing activities:

   income statement                                              unleveraged income statement
     sales                                                         net operating income (after tax)
   - costs of goods sold (cost of sales)
                                                                 + net financing income (after tax)
   = gross profit
   - operating expenses                                          = net earnings
        sales and marketing expenses
        research and development expenses
        general and administrative
        total operating expenses
   = operating income (EBIT) = earnings before
                                  interest and tax.
   ± other income and expenses
   ± interests income and expenses
   ± taxes
   = net earnings

Return on net operating assets RNOA

Residual operating income

                                            r = discount rate, the required rate of return for operation,
                                 NOA = net operating assets, g = growth rate, the rate at which residual
                                          operating income is expected to grow (terminal growth rate)

Value of operations

accounting for value                                                                                  page 7
                                                                                              February 14

                                           r = discount rate, the required rate of return for operation,
                                NOA = net operating assets, g = growth rate, the rate at which residual
                                         operating income is expected to grow (terminal growth rate)

Accounting principle 4

Book rate of return is an accounting measure determined by how one accounts for book value. It is
not necessarily a measure of real business profitability.

Accounting that keeps book values lower generates higher book rates of return and higher residual

R&D firms and brand name firms are good examples of where assets kept low on the balance sheet:
GAAP demand that investments in r&d and brand building must be expensed to the income
statement immediately rather than placed on the balance sheet.

Intangible assets (patents or copyright) and goodwill are booked to the balance sheet if purchased.
This almost always lower reported profitability, making the acquisition appears unprofitable when in
fact it may be otherwise.

Accounting for value finesses the problem of not being able to observe real economic profitability.
This is because of the way it works: One cannot increase future earnings without decreasing current
book value (or net operating assets)!

                       r = discount rate, the required rate of return for risk, NOA = net operating assets
                                       g = growth rate, the rate at which residual earnings are expected
                                                                            to grow (terminal growth rate)

accounting for value                                                                               page 8
                                                                                                February 14

Valuation principle 6

Accounting for value produces valuation that correct for the accounting employed; as earnings can
be generated by accounting methods only by reducing book value, the appropriate valuation is
preserved by employing book value and earnings together.

Conservative accounting keeps book value low in the balance sheet and defers earnings to the
future, producing higher book rates of return, higher residual earnings, and higher P/B ratios.

Accounting principle 5

Conservative accounting with investment growth induces growth in residual income.

Uncertainty lies in the future sales growth, in profit margin and asset turnover. These three
accounting features connect to the business and they connect the business to residual operating
income that measures value added.

About cost of capital
A valuation model is a way to think about valuation, not necessarily a direct prescription of how to
do it.

Beware of plugging in an assumed discount rate, r, the so called cost of capital or required return.
After fifty years of research, with Nobel Prizes won, we do not know how to measure the cost of

The capital asset pricing model (CAMP) requires inputs of covariances, betas, and expected market
risk premium, all of them expectations (in the mind of the beholder) rather than concrete
observables. Plugging in a CAMP estimate for the cost of capital into the validation formula is simply
adding speculation to the valuation.

In theory, asset pricing has it right, one’s required return depends on risk and one’s price for talking
on risk. In CAMP, beta is the risk and the market risk premium is the price of risk.

                                                   [        ]

                                               rf = risk free rate, e.g. risk free government long bond rate
                                      rp = risk premium, rm =average market risk, β = beta = relative risk

accounting for value                                                                                 page 9
                                                                                              February 14

However, one’s price of risk is a very personal thing, it depends on one’s tolerance for risk, so
objective measurements of a risk premium is misdirected – individuals’ feeling about risk and the
risk premium might differ significantly.

The fundamentalist approaches the market not with a precise cost of capital in mind to challenge the
price, but with a question: What is my expected return to buying at the current market price?

The market price for operations (the enterprise price, PNOA) is the market price of the equity plus net

                                                      r = discount rate, the expected return for buying
                                                                   the stock at the current market price
                                                                             given a growth forecast, g,
                                           the anchoring book value of net operating assets, NOA ,and
                                                              the forward return on book value, RNOA.

To answer the question above, one has to reverse engineer the equitation (the model) to solve for r:

Weighted average growth formula

                                   [               ]           [(        )       ]

                                            NOA / PNOA = the book value of net operating assets, NOA,
                                                      relative to the market price of operations, PNOA,
                                                            RNOA = the forward return on book value,
                                                              or weighted average of the profitability
                                                                            g = expected growth rate

As NOA x RNOA = operating income the weighted average return can be expressed as

                               [                           ]        [(       )       ]

                   [                                   ]        [                         ]

The term [operating income / PNOA] is the forward (enterprise) earning yield, and that is the
expected return if this were a bond. But stocks can yield growth, and thus the addition of the second
(growth) term:

The weighted average growth formula is just the expected return formula for a bond (that does not
yield growth) adapted for a stock (that can yield growth!

accounting for value                                                                             page 10
                                                                                                  February 14

Accounting modelling of risk
One does not buy a stock, one buys a business, and when buying a business, know the business.

Accounting for risk models uncertainty as a set of accounting outcomes rather than price outcomes;
uncertainty is described as a set of possible financial statements the firm could end up reporting
under different scenarios.

Uncertainty is inherent in laying out different scenarios and in forecasting the outcomes in those
scenarios. But past business experience guides. In negotiating with Mr. Market on price (and his
implied growth rate), your advantage lies in understanding the business as a set of alternative path
that the business can take.

The modeling of alternative path often produces insights into opportunities or dangers.

E/P, P/B, and accounting for growth
On an unleveraged basis, the expected return (for the operations) is:

                                    [                   ]       [(            )       ]

                                [                           ]        [(           )       ]

On a leveraged basis, the expected return (on equity) is:

                                        [               ]       [(        )   ]

                                        [               ]       [(        )   ]

                                            r = discount rate, the weighted average growth, b = book value
                                                   g = expected growth rate, p = price of equity (stock price)

Accounting principle 6

Under uncertainty, (conservative) accounting defers the recognition of earnings to the future until
the uncertainty has been resolved, and the deferral of earnings results in earnings growth.

Accounting, as practiced for centuries, does not recognize earnings until there has been significant
resolution of uncertainty.

accounting for value                                                                                  page 11
                                                                                               February 14

Misconception about historical cost accounting
Traditional historical cost accounting carries assets and liabilities on the balance sheet at their cost.

Fair value accounting reports the balance sheet at current values. But value is always in the mind of
the holder.

Historical cost accounting does not ignore value added: It updates the balance sheet for value added
when the firm trades with customers. In the parlance of modern finance: Value is not booked to the
balance sheet until the firm has a low-beta asset like a receivable or cash from customers. In
contrast, fair value accounting is booking value up font and presents a risky balance sheet

If value is missing from book value, it can be plugged with earnings from the income statement.
That’s what residual income valuation does.

Accounting principle 7

The stock return is always equal to earnings plus change in the price over book value for the earning

Prize minus book value is an error in the balance sheet that fair value accounting and proponents of
intangible asset accounting maintain is a failure of accounting. But accounting principle 7 says that
omission of value from the balance sheet does not matter if the error on the balance sheet at the
end of the period (pricet – book valuet) is the same as that in the beginning (pricet-1 – book valuet-1),
the error cancel. Valuation tolerates accounting error in the balance sheet if that error is constant
(no growth).

More generally: The omission of assets from the balance sheet is mitigated by the income
statement and cancelling errors. In other words, it does not matter if intangible assets are missing
from the balance sheet if earnings from those intangible assets are flowing through the income

The accounting that includes earnings explains almost all the value that the market sees in the price.
The no growth valuation anchors one for the question of whether value should be added for
speculative growth, whether the market’s additional value for growth is appropriate.

accounting for value                                                                               page 12
                                                                                            February 14

Accounting for value: A balance sheet vs. income statement focus
Accounting for value recognizes that value is missing from the balance sheet, but is added in the
income statement, so valuation is a matter of using the income statement and balance sheet

Earnings are the summary number from the deployment of all assets in the balance sheet (jointly).
The earning number serves to correct a balance sheet that cannot hope to recognize business value
(e.g. value added from intangible assets not on the balance sheet).

Business is all about entrepreneurial ideas to deploy assets together with people, relationship, and
a myriad of other “intangibles” to get an edge and add value.

The intelligent investor and the intelligent account
Benjamin Graham saw investing more as a matter of good thinking than technique.

First and foremost, accounting for value supplies a way of intelligently thinking about valuation, it
supplies the mental thinking for the intelligent investor. Insights from intelligent investing in turn
provide insights into intelligent accounting.

The intelligent investor…

              …understands that the risk in investing is the risk of paying too much, so
               seeks to understand the difference between value and price.

              …distinguish accounting value from speculative value; he accounts for value.

              …thinks in terms of accrual accounting rather than cash accounting.

              …sees value in terms of where book value will be in the future and what will
               be the return on book value.

              …will not pay for sales growth, asset growth, or even earning growth, but
               only for residual earning growth.

              …thinks like a conservative accountant.

              …understands that investing is not a game against nature but against other

              …is honest about not knowing the cost of capital so focuses instead on the
               expected return to buying at the market price.

Among the tools the intelligent investor employs are…
1. …no growth valuation

accounting for value                                                                            page 13
                                                                                                  February 14

                       r = discount rate, the required rate of return for risk, b = book value g = growth rate,
                            the rate at which residual earnings are expected to grow (terminal growth rate)

2. …benchmark growth valuation


                              rf = risk free rate, e.g. risk free government long bond rate, rp = risk premium,

3. …unleveraged accounting valuation

                                               r = discount rate, the required rate of return for operation,
                                    NOA = net operating assets, g = growth rate, the rate at which residual
                                             operating income is expected to grow (terminal growth rate)

accounting for value                                                                                  page 14
                                                                                                  February 14

4. …the weighted average return formula

                                  [                 ]   [(            )       ]

                            [                      ]    [(            )       ]

                 [                                  ]   [                                    ]

                                                  NOA / PNOA = the book value of net operating assets, NOA,
                                                            relative to the market price of operations, PNOA,
                                                                  RNOA = the forward return on book value,
                                                                     or weighted average of the profitability
                                                                                   g = expected growth rate

On a leveraged basis, the expected return (on equity) is:

                                      [             ]   [(       )        ]

                                      [             ]   [(       )        ]

                                             r = discount rate, the weighted average growth, b = book value
                                                    g = expected growth rate, p = price of equity (stock price)

accounting for value                                                                                  page 15

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Description: Accounting for Value teaches investors and analysts how to handle accounting in evaluating equity investments. The book's novel approach shows that valuation and accounting are much the same: valuation is actually a matter of accounting for value.
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