Book Review: Financial Statement Analysis for Value Investing

Monetary Assertion Evaluation for Worth Investing. 2025. Stephen Penman and Peter Pope. Columbia College Press.

The self-discipline of worth investing has had a troublesome time of late. The relentless ascent of passive funding methods, the extended outperformance of development shares because the World Monetary Disaster, and the hovering general valuations in developed markets (the place time-tested valuation rules now not appear to use), to call however just a few, have all contributed to its struggles. Consequently, the heirs of the Graham and Dodd custom are numbered as of late and relegated to deep-value methods in rising markets or Japan. Is that this merely a short lived aberration, or does the custom want some refinements to stay related in at this time’s monetary panorama?

In opposition to this backdrop, Stephen Penmanthe George O. Might Professor Emeritus at Columbia Enterprise College, and Peter PopeProfessor Emeritus of Accounting on the London College of Economics, have revealed a 432-page tome entitled Monetary Assertion Evaluation for Worth Investinga piece firmly rooted within the Graham and Dodd worth investing custom. The ebook additionally expands on the framework developed by Penman in his 2011 work, Accounting for Worth.

In each books, readers will encounter basic worth investing ideas, equivalent to negotiating with Mr. Market or the significance of a margin of security, and a few insights from trendy portfolio concept, such because the neutrality of dividends or an organization’s capital construction in creating worth for shareholders. Practitioners will discover this shocking and eclectic mixture of concepts refreshing and enlightening. Because the authors succinctly state within the introduction:

You’ll discover the ebook contrasts with many funding books. The ever present beta will not be of highest precedence by far. The frequent discounted money circulate (DCF) is put apart. Certainly, the ebook is skeptical about valuation fashions usually. Maybe surprisingly, the ebook takes the place that it’s best to suppose that “intrinsic worth” doesn’t exist. For a worth investor that feels like heresy, however intrinsic worth is simply too exhausting to pin down. That requires an alternate method to be placed on the desk, one which challenges the market worth with confidence. Some traders see the choice as buying and selling on multiples, good beta investing, issue investing, and extra. The ebook brings a critique to those schemes.

So, what do the authors suggest? The cornerstone of the ebook is the residual earnings mannequin. First formalized within the Eighties(1) and Nineteen Nineties(2)a lot later than different valuation frameworks such because the dividend low cost mannequin, the residual earnings mannequin was popularized within the Nineteen Nineties by the consulting agency Stern Stewart and briefly adopted by the administration groups of a number of giant U.S. companies to gauge whether or not their funding choices have been creating worth for his or her shareholders. Nevertheless, regardless of quite a few tutorial papers on the mannequin, its adoption by practitioners has remained restricted, lagging behind extra extensively used approaches equivalent to valuation multiples and the free money circulate mannequin.

As a fast refresher, the residual earnings mannequin instructs us to consider valuation by way of the lens of the long run residual (or financial) earnings {that a} enterprise is anticipated to generate. Residual earnings are merely accounting earnings after making an allowance for a value of capital cost. These future residual earnings should then be discounted again to the current and added to the corporate’s present ebook worth to reach at a valuation for the fairness. Notably, if an organization’s return on fairness matches its value of capital, it is going to generate accounting earnings however no residual earnings, which means that its shares ought to commerce at ebook worth. The class of the mannequin lies within the seamless integration of enterprise fundamentals with accounting figures, which in flip produce a valuation for the investor.

Though the three valuation frameworks (dividends, free money flows, and residual earnings) are mathematically equal, the residual earnings stands out for its capability to seize the true sources of worth creation for shareholders. Corporations that don’t pay dividends or reinvest in worthwhile development alternatives could be exhausting to worth utilizing the dividend low cost or the free money circulate mannequin, respectivel, however they don’t hinder the residual earnings framework.

The rationale this mannequin captures worth creation extra precisely (and earlier) is rooted within the accruals that govern present accounting techniques. Whereas so-called “money accounting” is commonly favored by practitioners over accrual accounting on the oft-touted premise that money is nearer to “exhausting and chilly information” whereas unscrupulous administration groups can simply manipulate accruals, Penman and Pope present that this typical knowledge is solely misguided. First, money flows themselves may also be manipulated by administration groups.

Second, there are a plethora of transactions that don’t contain money flows but nonetheless shift worth between stakeholders, with inventory compensation being in all probability probably the most outstanding instance. However most significantly, earnings are normally acknowledged sooner than money flows underneath the “realization precept.” For example, gross sales on credit score are acknowledged earlier than the corporate will get the money, capital investments are depreciated over time (growing earnings on the onset of the funding), and pension obligations are accounted for instantly, despite the fact that money won’t circulate out of the corporate to pay the guarantees till many years later. The necessary implication for traders valuing shares in the true world, the place the long run is unsure, is that “(w)ith this earlier recognition of worth added, there’s much less weight on a terminal worth in a valuation.”

In abstract, an accounting system primarily based on accruals and the belief precept inherently displays sound fascinated with how companies create worth for traders, in addition to some tips for understanding threat and return. Worth is capitalized on the steadiness sheet solely when the knowledge of the funding is excessive, and subsequent earnings are added to ebook worth solely when they’re realized. From this standpoint, various types of “carrying” the accounting ebook, equivalent to honest worth accounting, fail to uphold these rules. All through the ebook, Penman and Pope criticize honest worth accounting for encouraging speculative conduct by putting unsure values on the steadiness sheet, which finally contributes to investor hypothesis — as was exemplified throughout the dotcom bubble.

The ebook devotes many chapters to refining the normal residual earnings mannequin, which, resulting from its reliance on fairness metrics equivalent to ebook worth, internet earnings, and return on fairness, fails to adequately handle the problem of monetary leverage. The purpose right here is that one may suppose that including leverage would mechanistically create worth for shareholders since larger leverage would increase residual earnings by growing the return on fairness.

As Penman and Pope clarify, nonetheless, this line of reasoning is flawed, as the rise in leverage will improve the danger of the funding and, thus, the low cost charges, leaving the valuation unaffected. To resolve this, the authors introduce the residual working earnings mannequin, which makes use of enterprise worth metrics, e.g., internet working belongings as an alternative of shareholders’ fairness, internet working earnings as an alternative of internet earnings, and so forth. In doing so, this mannequin redirects the investor’s consideration to the true supply of worth creation in any firm: the operations of the enterprise.

Lastly, the ebook leaves some area for the “development versus worth” debate, a subject Penman himself explored in a 2018 Monetary Analysts Journal paper(3)in addition to the connection between agency measurement and fairness returns. Readers will discover {that a} coherent accounting framework and its implications for the way valuation multiples work go a protracted technique to understanding the problems at stake right here. Penman and Pope argue that simplistic and sometimes deceptive labels equivalent to “development” or “worth” fall quick in advancing the dialog and can’t exchange a radical understanding of accounting rules.

In conclusion, practitioners will discover Penman and Pope’s ebook not solely extremely related but additionally brimming with invaluable insights. What units this work aside from numerous different “investing” manuals is its formidable intention: to supply a collection of disconnected anecdotes and a cohesive and various framework for difficult market costs. The authors skillfully intertwine theoretical depth with ample real-world examples, reinforcing the reader’s hard-earned intuitions. I’ve little question that this ebook will change into a permanent basic within the Graham–Dodd custom and maybe the Holy Grail for future generations of clever traders.

(1) See, for example, Okay. Peasnell, “Some Formal Connections Between Financial Values and Yields and Accounting Numbers,” Journal of Enterprise Finance and Accounting 9, no. 3 (1982): 361–381.

(2) J. Ohlson, “Earnings, Ebook Values, and Dividends in Fairness Valuation,” Up to date Accounting Analysis 11, no. 2 (1995): 661–687.

(3) S. Penman and F. Reggiani, “Fundamentals of Worth versus Development Investing and an Clarification for the Worth Entice,” Monetary Analysts Journal 74, no. 4 (2018): 103-119.