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Home > Blogs > Anthony Harrington > 'Accounting for Value': Ignore this at your peril, part 3

'Accounting for Value': Ignore this at your peril, part 3

Accounting principles | 'Accounting for Value': Ignore this at your peril, part 3 Anthony Harrington

In his book Accounting for Value Steven Penman, Professor of Accounting at the Columbia business school, argues that anyone concerned with real value (as opposed to speculative notions of value) should welcome modern advances made in financial models and financial engineering, but should always subject the results of such models to the test of common sense.

"Don't anchor valuations on speculation"

Principle no. 7 of Penman’s ten common sense principles, which he calls the “soft principles of yesteryear”, (principles “distilled from years of practice” by fundamental investors), encapsulates this point: “Anchor a valuation on what you know rather than on speculation”.

As an example, which has nothing to do with mathematical models, Penman cites with approval the way the accounting standards setting bodies resisted market pressure in the 1990s to take speculative valuations for “intangible assets” onto the balance sheet of companies. With IT mania rising and preparing the ground for the 2001 dot.com bubble, a belief arose that value no longer resided in tangible assets like bricks and mortar, but in intangibles such as “innovative ideas” and new web-based platforms.

Soaring market valuations for newborn internet companies, who would supposedly make fortunes from their innovative approaches, caused many to claim that accounting should transform itself to “capture” this new source of value. In fact, as the dot.com bust showed all too clearly, investors were for the most part chasing a mirage and there was no value there. Fundamental investors, however, took note of the fact that the vast majority of the dot.coms were making losses, with no profits in sight, and “anchored” themselves on what they saw, not on what was promised.

They might have missed out on grabbing a significant stake in Amazon.com by so doing, but they surely saved themselves from losing a fortune on fastbuck.com and harebrained-idea.com. Penman backhands the accounting standard setting bodies elsewhere in the book, particularly in the introduction, for displaying tendencies to stray from the true path, but he gives them full credit for seeing that intangibles can melt like the morning mist.

Miller and Modigliani

This does not, of course, mean that those concerned with fundamental values need to be crusty conservatives imbued with a deep hatred of change. Advances in financial engineering are to be welcomed. The Nobel prize winning Black-Scholes formula for valuing derivatives is a powerful tool and should be used – subject to common sense – as should the Nobel-winning Miller and Modigliani (who I will call M&M for ease) discovery that value is not affected by dividend payouts. (If a company pays a shareholder a dividend of £1, the shareholder is better off by £1 in her pocket, but worse off in that the asset base of the company has gone down by the same amount – which makes the point that value is not affected by dividends.)

However, Penman points out that the dividend irrelevance principle of M&M, as it is known, leaves us with a conundrum. “The value of a share is based on expected dividends, but the dividends that a firm pays, up to the liquidating dividend [where the firm ceases and all value is distributed to stakeholders] is irrelevant. This points to the need for an alternative valuation approach to dividend discounting.

“This idea [M&M] cuts across the ideas of the fundamentalists of old. They thought that a firm paying more dividends should be worth more. In their words, “A bird in the hand is worth two in the bush”. Miller and Modigliani showed them to be wrong.”

The point for those concerned with fundamental value, Penman cautions, is that “value is added by business activities, not from zero-value-added financial activities.” This point holds good for M&M’s second principle, that leverage (borrowing) adds nothing to a company’s value. At face value this principle looks daft, since borrowing is “fundamental” to businesses ability to initiate new projects, which in turn adds considerable value for shareholders, assuming the projects succeed.

Value and risk

However, M&M’s theoretical point focuses like a laser on that “assuming” bit. Borrowing adds value, but it also adds risk (the risk that the company does not succeed in generating value, but has indubitably generated debt), and the two (value and risk) precisely cancel each other out. Which is where Penman’s exhortation, “if you invest in a business know the business” comes soaring to the fore. Knowing the business helps the value investor judge whether the business, and the management team in particular, has the nous to see the project through to a successful conclusion, thus generating value from its borrowing. At the end of the day, of course, this point leaps outside of accounting, and is rather the lodestone by which one tests the value of accounting. As Penman’s First Principle puts it: One does not buy a stock, one buys a business”; so know your business.

This point stands in sharp contrast to modern quantitative investment strategies. I recently interviewed Janet Campagne, the CEO of QS Investors, which manages $13 billion of assets and advises clients on a further $89 billion. “I’ve never looked a CEO of a company in the eye to determine the validity of a company’s growth strategy” Campagne says, neatly defining the yawning gulf between “quants” and traditional analysts.

I’ll be covering the “quants” in future blogs, but the techniques of modern financial engineering raise a number of interesting issues that Penman seeks to address. We’ll pick those up in part 4.

Further reading on valuations and accounting principles:



Tags: fair-value accounting , financial engineering , fundamental value , inflation , mark-to , quants , Steven Penman , value investing
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