Stephen Penman’s Accounting and Valuation Principles

“If you read Graham’s The Intelligent Investor— and one is advised to do so— there is not much in the way of techniques or calculations. Rather, Graham instructs us how to think about investing. He writes as a sage, he offers wisdom. Investing, he says, is first about attitude and approach rather than technique.”

―Stephen Penman, Accounting for Value

Below a collection of the accounting and valuation principles that are discussed by Stephen Penman in his book Accounting for Value.

Accounting Principles

  1. Future book value=Current book value+Future Earnings―Future Dividends.
  2. Accrual accounting brings the future forward in time, anticipating future cash flows.
  3. a. Leverage increases earnings growth.
    b. Leverage increases profitability (the return on common equity).
  4. Book rate-of-return is an accounting measure determined by how one accounts for book value. It is not necessarily a measure of real business profitability. Accounting that keeps book values lower generates higher book rates-of-return and higher residual earnings.
  5. Conservative accounting with investment growth induces growth in residual income.
  6. Under uncertainty, (conservative) accounting defers the recognition of earnings to the future until the uncertainty has been resolved, and the deferral of earnings results in earnings growth.
  7. The stock return is always equal to earnings plus the change in the price over book value for the earnings period.

Valuation Principles

  1. To get a handle on value, think first of what the book value is likely to be in the future.
  2. If one forecasts that the rate-of-return on book value will be equal to the required rate-of-return, the asset must be worth its book value.
  3. To get a handle on value, think first of what the book value is likely to be in the future and, second, what the rate-of-return on that book value is likely to be.
  4. Growth that is valued does not come from earnings growth but from residual earnings growth.
  5. a. Leverage reduces the P/E ratio from the enterprise P/E if the enterprise P/E is less than 1/Borrowing cost.
    b. Leverage increases the P/E ratio over the enterprise price-to-book if the enterprise price-to-book is greater than 1.0.
  6. Accounting for value produces valuations that correct for the accounting employed; as earnings can be generated by accounting methods only by reducing book value, the appropriate valuation is preserved by employing book value and earnings together.

Source: Accounting for Value, Stephen Penman, Columbia Business School Publishing

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.


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