2025. Stephen Penman and Peter Pope. Columbia University Press.
The discipline of added value has had a tough time recently. The relentless rise of passive investment strategies, the longer outperformance of growth stands for the reason that global financial crisis and the increasing overall rankings within the developed markets (through which the evaluation principles evaluated now not appear to apply), all of them have contributed to their fights. As a result, the heirs of the Graham and Dodd tradition are actually counted and are in deep value strategies in emerging countries or Japan. Is this just a brief aberration or does the tradition need some refinements to stay relevant in today’s financial landscape?
Against this background, Stephen PenmanThe George O. May Professor Emeritus on the Columbia Business School, and Peter PapstThe emeritus professor of Accounting on the London School of Economics has published a 432-page area with the title, a piece that’s invested within the tradition of Graham and Dodd Value. The book also extends the framework developed by Penman in his work in 2011.
In each books, readers will encounter classic value -investing concepts, e.g. Practitioners will find these surprising and versatile combination of ideas refreshing and revealing. As the authors briefly determine within the introduction:
In contrast to many investment books, you can find the book. The ubiquitous beta is way from being a top priority. The common reduced money flow (DCF) is put aside. In fact, the book is skeptical about evaluation models basically. Perhaps surprisingly, the book takes up the position that it’s best to think that “intrinsic value” doesn’t exist. For a price investor that feels like heresia, however the intrinsic value is just too heavy to capture. This requires an alternate approach that’s placed on the table that questions the market price with confidence. Some investors see the choice as a trade with multipliers, smart beta investments, factor investments and more. The book brings a criticism into these programs.
So what do the authors suggest? The cornerstone of the book is the remaining income model. First formalized within the Nineteen Eighties[1] and Nineties[2]Much later than other rating frames resembling the dividend discount model, the remaining income model was made popular by the consulting company Stern Stewart within the nineties and briefly took over by the management teams of several large US corporations to measure whether their investment decisions create added value for his or her shareholders. Despite quite a few academic articles concerning the model, his introduction by the practitioners has only remained limited and remained behind the widespread approaches resembling evaluation multipliers and the Free Cashflow model.
As a fast refreshment, the remainder of the profit model indicates the lens of the longer term residual (or economic) income that is anticipated by an organization. The remaining gains are simply the results of the income after making an allowance for the capital costs. These future remaining income must then be returned to the current and added to the present book value of the corporate with the intention to achieve an assessment for equity. If an organization’s return on equity corresponds to its capital costs, it’s going to generate the accounting income, but no remaining income, which implies that its shares should act on the book value. The elegance of the model lies within the seamless integration of business basics with accounting figures, which in turn create an evaluation for the investor.
Although the three rating frames (dividends, free money flows and the remaining income) are mathematically equivalent, the residual income is characterised with the intention to capture the true sources of value for shareholders. However, corporations that don’t pay dividends or in profitable growth opportunities can be with the dividend discount or the Free Cashflow model, perspective, but should not hindered the residual income framework.
The reason why this model records the worth creation more precisely (and earlier) is predicated within the provisions that regulate current accounting systems. While the so -called “money accounting” is commonly preferred by practitioners before the delimitation of accounting to the usually adapted premise that money is closer to “hard and cold facts”, while unscrupulous management teams can easily manipulate how this conventional WSDOM is just erroneous. First, the money flows may also be manipulated by management teams.
Secondly, there are a number of transactions that don’t contain money flows and still shift the worth between the stakeholders, although the shares are probably one of the best known example. The most significant thing, nevertheless, is that the income will likely be recognized sooner than the money flows as a part of the “realization principle”. For example, credit sales to loans are recorded before the corporate receives money, capital investments are written off over time (increasing profit originally of the investment), and pension obligations are immediately taken under consideration, although the corporate only flows out of the corporate a long time later to pay the guarantees. The essential implication for investors who evaluate shares in the true world where the longer term is uncertain is “[w]This earlier detection of value creation has less weight on a terminal value when evaluating. “
In summary, it may well be said that an accounting system based on provisions and the belief principle inherently reflects the category of how corporations value investors and a few guidelines for understanding risks and return. The value is simply triggered to the balance sheet if the knowledge of the investment is high and subsequent income is simply added to the book value in the event that they are realized. From this perspective, alternative types of “carrying” the accounting book, resembling. Throughout the book, Penman and Pope criticize the fair value, which records the encouragement of speculative behavior through the promotion of the balance sheet, which ultimately contributes to speculation of investors – as illustrated throughout the dotcom bubble.
The book dedicates many chapters to the refinement of the normal residual income model, which doesn’t adequately concern the query of economic leverage on account of its trust in stock metrics resembling book value, net income and return on equity. The point here is that one might think that adding levers would make added value for shareholders, since a better leverage would increase the remaining result by increasing the return on equity.
However, as Penman and Pope explain, this argument is wrong because the rise in leverage increases the chance of investing and thus the discount rates and the evaluation isn’t affected. To treatment this, the authors set the residual income model of the remaining company, the corporate value metrics, e.g. B. Netto operating systems as a substitute of equity, the web operating result used as a substitute of net income, etc. This model directs the investor’s attention to the true source of value in every company: business activities.
After all, the book leaves some space for the controversy “Growth Value”, a subject that Penman himself was researched in a 2018 newspaper[3]in addition to the connection between company size and equity returns. Readers will find that a coherent scaffolding and its effects on how the rating weight works to grasp the issues here. Penman and Pope argue that easy and infrequently misleading inscriptions resembling “growth” or “value” are neglected within the further development of the conversation and can’t replace a radical understanding of the accounting principles.
In summary, the practitioners Penman and Pope’s book not only find great relevance, but in addition with invaluable findings. What distinguishes this work from countless other “investments” books is the ambitious goal: to supply quite a few non -connected anecdotes and a coherent and alternative framework for difficult market prices. The authors skillfully intertwine the theoretical depth with loads of real examples and strengthen the hard -earned intuitions of the reader. I actually have little doubt that this book becomes a everlasting classic within the Graham -Dodd tradition and maybe a holy grail for future generations of intelligent investors.
[1] See, for instance, K. Peasnell, “Some formal connections between economic values and returns and accounts”, No. 3 (1982): 361–381.
[2] J. Ohlson, “Income, book values and dividends in equity evaluation”, No. 2 (1995): 661–687.
[3] S. Penman and F. Reggiani, “Foundations of the value towards growth investments and an explanation for the value trap”, No. 4 (2018): 103-119.
