This course is about handling accounting information in value investing. The issue is straightforward: How do I infer value from such numbers as earnings, book value, cash flows, return on equity, and return on assets? What are the pitfalls? When can I be led astray? How do I make valid inferences? “Profitability” is an important valuation attribute, but does reported accounting profitability convey real profitability? If not, how do I handle the deficiency?
The answers to these questions require, first, an understanding of the integrity of the numbers that financial statements report and, second, an understanding of what a “clean” number tells us and what it does not tell us. The first question is the issue of so-called “earnings quality.” While we will be sensitive to the quality of the accounting in this course—and indeed develop some striking criticisms and make adjustments—our focus will largely be on the second, the issue of appreciating the value implications of accounting numbers. (There is a detailed course on earnings quality at Columbia Business School, Earnings Quality and Fundamental Analysis, B8008.)
Accounting numbers, used appropriately, are powerful aids to the value investor in understanding a business and the value in that business. However, they can be easily misused. A P/E ratio, for example, serves as an important input to a value investor, but the investor is in danger of being falsely cued if he or she does not appreciate what that ratio actually captures. A too-simple form of “value investing” trades on P/E and price-to-book (P/B) under the label, “Value versus Growth” investing, but the uninitiated is in danger of falling into the Value Trap. In this course you will understand the Value Trap and how to avoid it. More importantly, you will appreciate how a dedicated approach to value investing deals with accounting numbers to understand when price is different from value. Indeed, the course will show how to bring the appropriate (possibly adjusted) accounting numbers together to challenge the market price and thus avoid the greatest risk in investing, the risk of paying too much.
The course title is that of my book, Accounting for Value. This easy-read develops the themes and the course flushes them out. By the end of the course, you should have the answers to the following questions:
• How do I understand the profitability of a business from the financial statements and what does that imply for the value of the business?
• Apple Inc. trades at a forward P/E of 11.5. What does that tell me? Is the stock cheap or expensive?
• Apple Inc. trades with a PEG ratio of 0.85. Is it cheap?
• The value investor is wary of taking on leverage. How does leverage affect accounting numbers such as earnings and return on equity, and how can those levered numbers lead me astray?
• The value investor is wary of buying growth, for growth is risky. How does the accounting tell me that prospective growth is risky?
• What is the Value Trap? How can I avoid it?
• Which accounting numbers do I have to be wary of?
• How do I use accounting numbers to understand the growth expectations built into the market price?
• How do I challenge the market price using accounting numbers?
George O. May Professor of Financial Accounting
Stephen Penman is the George O. May Professor in the Graduate School of Business, Columbia University where he is also co-director of the Center for Excellence in Accounting and Security Analysis and director of the Masters Program in Accounting and Fundamental Analysis.
Prior to his appointment at Columbia in 1999, Penman was the L.H. Penney Professor in the Walter A. Haas School...