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'Accounting for Value': Ignore this at your peril, part 1

Fair value accounting | 'Accounting for Value': Ignore this at your peril, part 1 Anthony Harrington

How does anyone - analysts or bankers or investors or even regulators, bless them - judge the value of a commercial entity of any scale? Why is this difficult? As Stephen Penman, professor of accounting at the Columbia Business School notes, the difficulty of forming judgements of value is rooted in the limited powers us poor humans have at absorbing and processing large amounts of information. Accounting, seen from this standpoint, is simply a way of consolidating information about an organization and its operations into a few key summary numbers that we can work with. So they had better be the right numbers…

Fair value accounting

But then you already knew that, right? PE ratios, profit forecasts, cash flow statements, these are all good “summary numbers” that are used all the time, so what’s new? Answer, a vast amount. Penman’s book, Accounting for Value (Columbia Business School Publishing) contains gems on every page – to the point that no one who deals with the market in any capacity should pass by this text until they have committed to memory as many points therein as their limited, mark one, human brains, can hold.

It is an unassailable fact that their ability to do their jobs, and even better, to reflect on their jobs, will be considerably improved by the effort. And God knows the world could use some thoughtful analysts, bankers, investors and, yes, regulators! If there had been a smidgeon of thought in the financial community the crash of 2008 would have been nipped in the bud way before it reached its full, horrendous flowering. Moreover, a large number of senior management types would have been given the bullet for gross dereliction of duty at a much earlier stage of the game.

In fact, if they had been Penman students, they would in all probability not have been remiss in their duties and would have had a vastly better grasp of risk and its relationship to value. Hence, one of the key causes of the crash according to, among others, President of the European Central Bank (ECB) Jean-Claude Trichet, namely the mispricing of risk, would have been addressed and resolved before it got a stranglehold on so many institutions.

Price and value

So what does the world according to Penman look like? Whence cometh the illumination? Let’s start with something simple. One of Penman’s “ten principles of fundamental investing” is an absolutely, well, fundamental distinction between price and value. As he puts it, “Price is what you pay, value is what you get.” The key risk for a fundamental investor concerns price, the risk of overpaying for value.

When you have this point firmly clutched in both hands, suddenly famous indexes such as the FTSE 100 or the S&P, look rather more questionable. Why? Because they splendidly confound price and value.

A fundamental investor knows that price is an excellent source of information. However, he/she also knows that setting prices by reference to prices – the quintessential job of an index – is, in effect, to construct a feedback loop, and price feedback loops are wonderfully good at inflating bubbles. To see why, watch the bidders at an auction bidding up the price. Again and again the price setting process gathers its own momentum so that the poor old bidder loses track of the value of what she is bidding for. In fact the auctioneer’s job, in a nutshell, is to encourage this confounding of value and price by raising those Keynesian animal spirits amongst the bidders. And what is a market index if it is not a kind of proxy for an auctioneer? The index is rising – get in! It’s falling – get out! Going, going, gone!

Fundamental value

The fundamental investor, with Penman’s text firmly held in one hand, stays steady amongst all this hullabaloo. They know they are not buying a stock, they are buying a business (Principle Number 1 of 10 in Penman’s list). Moreover, they know that while prices can contain a giddy element from time to time, prices will return, over time, if one is patient, to fundamental values. (Penman puts it wonderfully – “the expectations of others that go into pricing are not necessarily those of a rational accounting”. No indeed, quite often not very rational at all, particularly when tulip mania takes over).

Of course, this point should not be made without being accompanied by Keynes’s warning that “markets can stay irrational for longer than you can stay solvent”.  Penman himself makes the point that while Cisco Systems and Dell Computers are both excellent businesses, they were wildly overpriced by 1997 in the run up to the bubble, with both trading at multiples of 100 times earnings ratios. However, a fundamental investor who waited for the pricing of these stocks to return to fundamental values would have had to wait three long years for the price to resume its acquaintance with fundamental reality. That is a long time to miss out on an upward spiralling rally.... The point goes a long way towards explaining why the performance of  value managers looks so wildly uninspiring when markets go streaking off on a tear.

In part 2 we will look at why Penman is underwhelmed by the current accounting standard setting process,  which he argues, does little to provide solid accounting tools for the value investor. Mark-to-market? Do me a favour...

Further reading on fair value accounting:

Tags: Accounting , fair-value accounting , fundamental value , price , price-to-earnings ratios , value
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