Can We Better Account for Value?

Valuation models are the most widely taught tool for future investors, but they’re often abandoned in practice. Better accounting may offer a more concrete solution.

The first dot-com bust in 2000 destroyed 78 percent of the value of the Nasdaq Composite index. The tech bubble had been inflated largely because venture capitalists — and then investors on the public markets — vastly overestimated the viability of companies’ business models and their future earning potential.

A similar trend may be occurring today as tech companies from Uber to Twitter, valued at billions of dollars despite often operating cash-negative even years after launching, continue to explode in price. For the banks and venture capitalists invested in those companies, Stephen Penman explains, the companies’ valuation and potential future earnings are of utmost importance: those numbers may determine whether they succeed or fail and if investors will one day see a payday.

“The refrain of the value investor is ‘price is what you pay, value is what you get,’ ” Penman says. “But while the price the stock market is asking the investor to pay is easy to see, ‘value’ is elusive.” For decades, the standard approach has been to employ a valuation model, like the discounted cash flow model. Despite their common use, as both perceptive students and practiced professionals know all too well, the results are often far from precise. Small changes to the discount rate or the growth rate in these models have a big effect on the calculated value.

“Despite years of research,” Penman explains, “we haven’t been able to come up with a reliable measure of the discount rate — the so-called cost of capital — and the long-term growth rate for these models is anyone’s guess.” Cost of capital estimates are speculative, and that inherent uncertainty is only magnified by hypothetical growth rates. The impression of precision offered by the mathematical formulas of valuation models, then, is largely specious. Valuation models can further “lend themselves to ‘playing with mirrors’ to support a desired valuation,” Penman says.

In practice, valuation models are often discarded altogether in favor of rough-cut methods such as pricing on the basis of comparable firms or simple price-to-earnings ratios. But such methods rely on limited information and, as Penman asserts, “ ‘ignore information at your peril’ is also among the central tenets of value investing.” The trader on the other side of the deal may well know more than you.

“Rather than building questionable growth and cost-of-capital estimates into a valuation model, what’s needed is sound

accounting that provides a basis to challenge the growth implicit in the market price.”

“Prices are speculative,” he continues. “To challenge that, you need to separate what you know from the speculation inherent in the market price.” First and foremost, value investing requires a sound knowledge of the business, but it also requires a representation of the business in terms of numbers that connects to the value in the business, and that, according to Penman, is precisely what accounting can offer.

“Rather than building questionable growth and cost-of-capital estimates into a valuation model,” he says, “what’s needed is sound accounting that provides a basis to challenge the growth implicit in the market price and gives insight into risk and the risk premium the investor might require.” In a sense, then, valuation is really a matter of accounting — accounting for value. And rather than deferring to simple schemes like price-to-earnings ratios — which are based on just one piece of information, earnings — accounting should provide investors with a fuller set of numbers, offering a more complete picture of a firm’s value to compare price against.

“Fundamentally, the question is: what is ‘good’ accounting and what is ‘bad’ accounting?” Penman says. “The answer to that question has implications not only for valuation and investing but also for standards setters like the Financial Accounting Standards Board and the International Accounting Standard Board that govern the way financial information is reported to investors.”

Stephen Penman – Stephen Penman is the George O. May Professor in the Graduate School of Business, Columbia University.   He is also co-director of the Center for Excellence in Accounting and Security Analysis at Columbia Business School.

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