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April 18, 2011

Price Is What You Pay; Value Is What You (Hopefully) Get

A new book from Chazen Senior Scholar Stephen Penman helps investors avoid the risk of paying too much.

Rebecca McReynolds

While US and international accounting standards are moving closer together, they are actually becoming less useful to investors, says Stephen Penman, a Chazen senior scholar and the George O. May Professor of Accounting at Columbia Business School. By incorporating such concepts as fair value accounting, discounted cash flow and the long-standing capital asset pricing model into a uniform accounting framework, regulators are creating more room for speculation within the corporate balance sheet, he says. And speculation is an anathema to fundamental investors. “If the accountant starts speculating, then the investor loses his anchor,” he says.

In his new book, Accounting for Value, Penman throws those investors a lifeline. By breaking down increasingly complicated balance sheets into simple math, he highlights key warning signs and provides the tools necessary to determine the real value of any stock.

Set Your Anchor

Fundamental investors are nothing if not cynical. Rejecting efficient market theory, which is steeped in the belief that all markets are rational and therefore the market price always represents a stock’s fair value, fundamentalists are willing to go the extra mile to confirm each stock’s worth. Unfortunately, Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) fall short when it comes to helping investors decipher a stock’s underlying value, Penman says.
Penman suggests investors begin analyzing any prospective investment by separating those things that you can be certain about, such as this year’s sales, from any analysis that requires speculation, such as revenue projections that attempt to look beyond the next year or two. “With this parsing of the future, you establish your anchoring no-growth valuation and maintain your cynicism about growth prospects,” Penman writes.

Beware of Growth

Of course, growth is the underlying goal for any investment, and there is no way to completely separate future growth potential from the price of a stock. But you can make sure you understand what you are buying and ensure that you are not overpaying for that growth, Penman says. For example, investors who follow the old adage to “buy earnings” can miss the boat if they don’t understand the accounting used to post those earnings. Accounting devices such as accelerated depreciation, deferred revenue, and one-time write-downs can blur the lines between real income from operations and paper profits, Penman warns.

So he advises readers to skim past the consolidated earnings report and focus on residual operating income, defined as the net operating income that a company earns above the minimum required return on its operating assets. For example, between 2005 and 2009, Starbucks Corp. posted revenue growth of 53 percent and its operating income climbed nearly 29 percent, driven in large part by the company’s aggressive growth through franchising. Using a minimum required return of 10 percent, though, Penman shows that Starbucks’ residual operating income over that time actually dropped, along with its stock price. In 2009 the company cut thousands of jobs and closed 300 stores.

Solid investments should not only maintain sales growth but must also increase the amount of sales they generate from existing assets. With Starbucks, or any other retailer, same-store sales are a more important indicator of future profitable growth than revenue growth generated by opening more stores, he notes.

Write Off Leverage

Most investors understand that leverage is dangerous because it can turn on you when things go south, Penman says, but most investors don’t account for that risk when calculating a company’s valuation. Yes, leverage can boost earnings growth and even increase residual earnings, but growth generated by leverage does not typically add value, he adds. To factor a company’s real worth you need to back out that debt. Unfortunately, both US and international accounting standards dump operating and financial assets into the same bin.

Investors can separate those items themselves by dividing the balance sheet in two sections. On one side list operating assets, such as receivables, inventory and real estate, and operating liabilities, including accounts payable, deferred revenue, and accrued expenses. On the other side list financial assets, including interest-bearing accounts or other types of short-term investments. Financial liabilities include the debt incurred from raising cash to fund the business, such as bonds and bank loans. By subtracting net debt from net operating assets you get a true picture of shareholder equity, Penman says.

Name Your Price

Once you have a firm grasp on a company’s current value, the final step is to determine if the current market price adequately reflects the risk-reward trade-off inherent in investing. To do that, even fundamental investors need to factor in the speculative value of potential future growth. Penman suggests using the current US government bond yield as the anchor for pricing growth. Because Treasuries are considered risk-free, you would require a premium for assuming any risk over that risk-free rate. The higher the projected growth rate, the higher the risk premium, he says.

“Every investor has to deal with speculation, and speculation is in the eye of the beholder,” he says. With Penman’s “accounting for value” framework, though, investors have a better tool for determining the price that is right for them.

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