Why did you write this book?
I wrote the book to expose investors to the idea that rather than pulling the standard set of tools out of the box, such as CAPM (capital asset pricing model), cost-of-capital, and discounted cash flow analysis, investors can extract great value by engaging with accounting and financial statements in the mode of fundamental analysis. The latter part of the book is addressed to accounting regulators — the standard setters who design accounting — with an appeal for better accounting that fundamental analysts can rely on.
What’s wrong with CAPM and the rest of the standard toolbox?
It’s well-recognized that CAPM does not work in practice. Estimating the expected return on the market over the next 10 years relative to the risk-free rate — with a myriad of non-stationary betas and covariances — is just too complex of a problem for the investor. It builds too much of what Benjamin Graham would call speculation into the valuation. We’ve had two bubbles and subsequent crashes in the last 10 years. Prices went crazy for Internet start-ups in the late 90s and then for housing over the last decade. We don’t seem to have learned any lessons, such as, how do you get grounded in the fundamentals? That’s what this book is about.
As an investor, I have two choices. I can have faith that markets are efficient and believe that just by holding stocks they will outperform bonds in the long run. That’s what the Church of England did, putting all of its pension funds into stocks and losing most of its money. That is risky. The alternative is to kick the tires, to investigate, pulling information about a company together to get a good look at value. Price is what you pay, value is what you get. There’s a huge amount of information about firms but accounting can pull it together for you. Accounting for value, as the book’s title says.
As for the cost of capital, we should be honest with ourselves and acknowledge that we don’t really know the cost of capital. People grind that idea down Wall Street, but it’s sort of a dirty little secret: we can’t calculate the cost of capital.
But you don’t need to know the cost of capital! Rather than trying to determine it, investors should ground themselves in the accounting and ask, “If I buy at the current market price, what do I expect to earn as a return?” The analogy is to ask, “What is the expected yield to buying a bond at the current market price?” The answer indicates whether an investment is cheap or expensive. But you need some accounting to get the answer, and the book shows how.
Why do you view paying too much for an investment as the primary source of risk for investors?
Again, that’s a departure from modern finance and from the efficient markets line of thought. If you go with the efficient markets view, you just buy the stock at the market price without doing any analysis. You buy an ETF or an index fund. Under the efficient markets theory, there is no danger in paying too much. But when you get down to it, that leaves you exposed.
If it’s 1999 and Dell is selling at 70 times earnings, you’re in danger of paying too much. If it’s 2007, you might well check whether you are paying too much. You protect yourself from overpaying for a stock or selling for too little by building in a margin of safety using fundamental analysis. And it is the accounting, relatively free from speculation, that provides the safety and anchors you for challenging the market price. Efficient market investing is passive investing that exposes you to risk that you can avoid. Active investing, grounded in the accounting, provides protection.
Fundamental analysis is well established, and experiencing somewhat of a resurgence, while behavioral finance is still getting on its feet. What does this new discipline have to offer fundamental analysis?
Behavioral finance has been spurred along by the experience we’ve had in these recent bubbles. The rational-man, efficient-markets view is very persuasive, but how can prices have gotten so out of line if people are so rational?
But while there is quite of lot of experimentation at the individual level, I don’t believe that behavioral finance has yet developed a persuasive alternative to the rational-man idea.
One thing I think everyone agrees upon is that we humans have limited information processing ability. We can only remember seven digits, they say. We’re limited, as individuals and collectively, and we need a rational system to pull the information together for us.
A good accounting system can offset our limited information processing ability. And it’s the issue of developing and exploiting good accounting — an accounting for value — that this book is all about.
What effect will the transition from FASB to IASB standards have on investors who want to follow the path you suggest?
Fair value accounting is the contentious issue. Fair value accounting puts prices on financial statements. Prices are speculative. Investors should put prices outside the door while they investigate the information, so they can challenge prices. And so should the accounting on which investors rely.
It’s worth noting that Benjamin Graham’s mentality came out of the shock of 1929, when accountants actually did fair value accounting. Graham called it putting water in to the balance sheet. All those fair-value asset write-ups evaporated in October 1929. In 1933, when the SEC was created, “no water in the balance sheet” was a firm principle. That position has been revised in the last 15 years and the SEC has gone along with it. I see that as dangerous. Enron is one example, it was basically a fair-value house of cards. The housing bubble is a good example: the prices of traded mortgages were going into the financial statement of banks. They got bubble financial statements and investors lost an anchor to challenge prices.
Accounting is all about the numbers. Yet your book is big on ideas and principles and relatively short on numbers. Why should investors care as much about ideas as they care about numbers?
Accounting should be driven by principles and the principles should be the principles of sound investing. It’s not a matter of coming up with rules and regulations. Accounting authorities tend to make very legalistic definitions of assets and liabilities, and if something doesn’t fit, it’s not accepted as an asset or a liability. Questions about how you arrive at those definitions aside, they have a legalistic set of accounting standards that are not oriented toward helping investors.
It can lead to a mess. For example, the notion of revenue recognition is based on earnings definitions, and if you violate those definitions, you violate GAAP. But the definitions are vague, so even well-meaning CFOs get caught all the time.
Accounting is in the end a design problem. You can make your accounting anything you like. The regulators receive a lot of pressure from corporations and the government to design balance sheets and financial statements the way management and politicians would like. I hope this book will help investors press the regulators — what should the accounting look like for investors? I hope the book will have that sort of influence.
You quip that a lot of things about accounting can be thrown out — but not the accounting jokes. What’s your favorite accounting joke?
I’m not sure there is a best accounting joke, but many could vie for the worst. Here’s one:
Q. What's an extroverted accountant? A. One who looks at your shoes while he is talking to you instead of his own.
A. One who looks at your shoes while he is talking to you instead of his own.
Stephen Penman is the George O. May Professor of Accounting, a senior scholar at the Jerome A. Chazen Institute for International Business, and co-director of the Center for Excellence in Accounting and Security Analysis (CEASA) at Columbia Business School.
Read an excerpt from Accounting for Value at the Columbia Business School Publishing site (PDF).