ACCOUNTING FOR VALUE

B8022, Spring, 2024

PROFESSOR NAME: Stephen Penman

Professor Office: Kravis 726

E-mail: [email protected]

Course meeting time: Monday 2:20pm – 5:35pm, Geffen 420

Office Hours: By arrangement

Teaching Assistant: MJ Song [email protected]

REQUIRED PREREQUISITES AND CONNECTION TO THE CORE

This course builds on material in Financial Accounting and Corporate Finance core courses and complements
courses on equity investing in the Value Investing Program and elective courses on fundamental analysis in the
Accounting Division. Capital Markets is a co-requisite, that is, it must be taken at the same time or before this
course. Material from the Managerial Economics and Strategy Formulation core courses is also relevant but
not required. Students should have a reasonable understanding of financial accounting principles, the balance
sheet, income statement, and cash flow statement, along with the basic principles of finance.

COURSE DESCRIPTION AND OBJECTIVES

The course works on basic value investing principles: Price is What You Pay, Value is What You Get; The
Primary Risk of Investing is the Risk of Paying too Much; Beware of Buying Growth, for Growth is Risky.

But the course has a particular emphasis: How does the investor handle the accounting information about
fundamentals in value investing? How does she infer value from such numbers as earnings, book value, cash
flows, return on equity, and return on assets? What are the pitfalls? When can he be led astray? How is
accounting handled to understand the value generation of a firm under study?

The answers to these questions require, first, an understanding of the integrity of the numbers that financial
statements report and, second, an understanding of what a “clean” number tells us and what it does not tell
us. The first question is the issue of so-called “earnings quality.” While we will be sensitive to the quality of the
accounting in this course—and indeed develop some striking criticisms and make adjustments—our focus will

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largely be on the second, the issue of appreciating the value implications of accounting numbers. (There is a
detailed course on earnings quality at Columbia Business School, Fundamental Analysis and Earnings Quality,
B8008.)

Accounting numbers, used appropriately, are powerful aids to the value investor in understanding a business
and the value in that business. However, they can be easily misused. A P/E ratio, for example, serves as an
important input to a value investor, but the investor is in danger of being falsely cued if he or she does not
appreciate what that ratio captures. A too-simple form of “value investing” trades on P/E and price-to-book
(P/B) under the label, “Value versus Growth” investing, but the uninitiated is in danger of falling into the Value
Trap. In this course, you will understand the Value Trap and how to avoid it. More importantly, you will
appreciate how a dedicated approach to value investing handles accounting numbers to understand when
price is different from value. Indeed, the course will show how to bring the appropriate accounting numbers
together to challenge the market price and thus avoid the greatest risk in investing, the risk of paying too
much.

In the course, accounting is dealt with as part of business analysis which is, after all, the prime focus in value
investing. We learn about the business via accounting numbers if they are handled appropriately. We’ll apply
accounting measurement to understand value added in (prospective) mergers and acquisitions, restructuring
of operations, and other corporate strategies.

With an understanding of how accounting connects to value, the investor is ready to engage in “accounting
arbitrage.” If the market fails to understand the subtleties on the accounting, that provides an arbitrage
opportunity for the insightful investor. Benjamin Graham’s “intelligent investor” is an intelligent accountant.
He or she knows how to account for value.

The course title is that of my book, Accounting for Value. This easy read develops the themes and the course
flushes them out. That is with the help of a new book, Value Investing By the Book. By the end of the course,
you should have the answers to the following questions:

• How do I understand the profitability of a business from the financial statements and what does that
imply for the value of the business?
• Apple Inc. trades at a forward P/E of 26.5. What does that tell me? Is the stock too expensive? What do
you make of Amazon’s trailing P/E of 71.7 after a price increase of 49% over the past 12 months?
• Apple Inc. trades with a PEG ratio of 2.4. Is it cheap or expensive? A PEG of 2.5 for Amazon? Which
stock is more attractive?
• The value investor is said to “anchor on the fundamentals” and eschew speculation. How does one
establish an anchorage using the financial statements?
• Benjamin Graham saw investing as a matter of “negotiating with Mr. Market.” How do the financial
statements become part of that negotiation…to argue with Mr. Market about the price?
• The value investor is wary of taking on leverage. How does leverage affect accounting numbers such as
earnings and return on equity, and how can those levered numbers lead me astray?

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 • The value investor is wary of buying growth, for growth is risky. How does the accounting tell me that
prospective growth is risky?
• How do I use accounting numbers to understand the growth expectations built into the market price?
• What is the Value Trap? How can I avoid it?
• In sum, how do I challenge the market price using accounting numbers? How do I use accounting
numbers to avoid the “risk of paying too much” for a stock?
THE TEXT FOR THE COURSE

The primary text for the course is:

Penman, S. and P. Pope. Accounting for Value: Financial Statement Analysis for Active Investors.

This book is in production for publication about May 2024. A prepublication copy is a on the Canvas page for
this course.

Further reading is in the following books:

Penman, S., Accounting for Value (Columbia University Press, 2011).

This book is written largely for practitioners, introducing and illuminating the issues
addressed in the course. Read the Introduction and the first two chapters of this book before
the class begins, then follow the book as an introduction to the topics as the course proceeds.

Also available in Chinese, Japanese, and Korean.

Another detailed text is Penman, S., Financial Statement Analysis and Security Valuation, 5th ed.
(Irwin/McGraw-Hill, 2013).

The international soft-cover version is the same material as the U.S. version (with a different cover), but much
cheaper. It is also available in Chinese, Japanese, Korean, and Portuguese.

You might also look at English, J., Applied Equity Analysis (McGraw-Hill, 2001) for a book that also handles
accounting numbers in equity valuation.

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CLASS FORMAT

This class requires in-person attendance, with video recording only on special request. Class sessions will
revolve around power point presentations, short exercise examples, and longer case discussions. Students are
expected to participate actively in class discussions and cases. Beware: Your professor likes to talk, so
challenge him with comments and questions. Students will receive a complete copy of notes for each class on
Canvas, along with advance case material for subsequent classes. Students should come to class well-prepared
to discuss issues and push for the resolution of these cases. Complete solutions to the cases will be posted to
Canvas after we have worked the cases in class.

METHOD OF EVALUATION

Course Project 50%

Final Exam 50%

The final exam will be a 90-minute exam in the final class session, open book.

Course Project

There are two alternatives for the course project:

1. Take one (or more) of the cases we worked in the course and flush it out more fully, applying it to a
larger number of firms or expanding on the issues to get more insights.

2. Evaluate investment in a particular company or sets of companies under a title something like,
“Challenging the Market Price of Company X Using Accounting Information” (you choose the X).

The project can be done individually or in groups up to four people. It should be no more than 15 pages in
length (exclusive of an appendix with detail on calculations involved). The submission will be graded on its
creativity, depth of understanding, rigor, and clarity in communication. Write it as if to a client whom you are
advising, not to a professor. It must be original work.

The project is due May 7, 2024. Deliver to [email protected] in one pdf file or to the Assistants’ station in
Kravis 1120.

Under Business School standards, the project is Type A (with the group self-selected) in the table below:

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 Discussion of Preparation of
Type Designation concepts submission Grade
group / group Permitted with By the group Same grade for
A designated group each member of
the group
group / Permitted Individually Individual
individual
B (No sharing of
any portion of
the submission)
individual / None of any kind Individually Individual
C
individual
(An optional category to be defined in detail by the individual faculty
D
member)

CLASSROOM NORMS AND EXPECTATIONS

Classroom activities are to be conducted in an atmosphere of mutual respect, engagement, and participation, with the
common goal of enhancing each other’s learning and mastery of the material. The professor wants to learn from you
also! The 3Ps of the Core Culture apply:

Present:
• On time and present for every session
• Attendance is required, although not tracked

Prepared:
• Complete pre-work required, expect cold calling
• Bring name plates to class

Participating:
• Constructive participation expected
• No electronic devices unless for class-room purposes. Laptops permitted, but only if open to the course
material

For each class, preparation involves:

(i) Preparing the case(s) assigned for the class session

(ii) Reading prescribed material
(iii) Reading over the class notes for the session, to gain some familiarity in advance and to prompt
questions you might raise in class.

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COURSE SCHEDULE AND TOPICS

Note: Cases must be worked prior to the class period. Case 1, STARBUCKS CORPORATION: KEEPING A
CASH BOOK must be prepared before the first class.

PP refers to Accounting for Value: Financial Statement Analysis for Active Investors by Penman and Pope
A4V refers to the Accounting for Value book by Penman
Cases are in the Case Book on the Canvas webpage. The case numbers refer to the case number in the
Case Book

________________________________________________________________________________________

WEEK TOPICS READINGS AND CASES

____________________________________________________________________________

1 Introduction to Fundamental Analysis PP Ch. 1 and 2

A4V Ch. 1 and 2

January 22 Value Investing Principles

Investing with Pricing Multiples

Cash Accounting for Value Case 1: Starbucks Cash

___________________________________________________________________________

2 Trading on Multiples and the Value Trap PP Ch. 2 and 3

A4V Ch. 2 and 7

January 29 Cheap Value Investing and the Value Trap Case 2: P/E, PEG, Growth

Anchoring Value to the Balance Sheet

____________________________________________________________________________

3 Accounting for the Market Price PP Ch. 4

A4B Ch. 3

February 5 Negotiating with Mr. Market Case 3: The FED Model

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 Case 4: Starbucks Again

____________________________________________________________________________

4 Accounting for Leverage and Financing Risk PP Ch. 5

A4V Ch. 4

February 12 Leverage and Return in Equity Case 6: Microsoft Valuation

Leverage and Growth

Leverage and the P/E and P/B ratio

____________________________________________________________________________

5 Accounting for the Profitability of the Business PP Ch. 6

A4V Ch. 4-5

February 19 Accounting for value in operating activities Case 8: Microsoft Unlevered

Accounting for Investment
Accounting for return on investment

____________________________________________________________________________

6 Accounting for Growth PP Ch. 7

A4V Ch. 5

February 26 The drivers of growth Case 10: Apple Adding Value

Challenging risky growth expectations

____________________________________________________________________________

7 Accounting for Risk PP Ch. 8

A4V Ch. 6

March 18 Risk and Return from Investing Case 11: BNSF Buffett

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 Case 13: Amazon

____________________________________________________________________________

8 Accounting for Value in Balance Sheet PP Ch. 9

A4V Ch. 8-9

March 25 Accounting for Operations Case 14: Microsoft

Accounting for Off-Balance Sheet Items Expected Return

Accounting for the Accounting in the BS Case 15: Challenge

Accounting for Risk in the Balance Sheet the S&P 500

____________________________________________________________________________

9 Accounting for Value in the Income Statement PP Ch. 10

April 1 Anchoring on Quality Earnings A4V Ch. 9

Identifying Sustainable Earnings and Case 16: Microsoft

Earnings Power Contingent Securities
___________________________________________________________________________

10 Accounting for Special Situations PP Ch.11

April 8 Valuation of a P@C Insurer Case 17: IBM: Challenging

Mergers and Acquisitions Growth

Restructurings

___________________________________________________________________________

11 Investing in Style PP Ch. 12

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 April 15 Value versus Growth Investing

Investing by Size

___________________________________________________________________________

12 Keeping a Book on Liquidity PP Ch. 13

April 22 In-class Final Exam

___________________________________________________________________
REVIEW SESSIONS

Friday, February 23

Friday, March 29

Friday, April 19

All review sessions are TBA

FINAL EXAM

April 22, in class

DUE DATE FOR PROJECTS

May 7, 2024. Deliver to [email protected] in one pdf file or to the Assistants’ station in Kravis 1120.

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 STEPHEN H. PENMAN

Stephen Penman is the George O. May Professor in the Graduate School of Business, Columbia University where
he is also co-director of the Center for Excellence in Accounting and Security Analysis and director of the Masters
Program in Accounting and Fundamental Analysis. He is also a Distinguished Professor at Bocconi University.

Prior to his appointment at Columbia in 1999, Penman was the L.H. Penney Professor in the Walter A.
Haas School of Business at the University of California at Berkeley. He joined Berkeley in 1977. From 1990-95
he served as Chair of the Professional Accounting Program and Chairman of the Accounting Faculty at Berkeley.

Penman has served as a Visiting Professor at Bocconi University the University of Padua, the London
Business School, the Jan Wallander Visiting Professor at the Stockholm School of Economics, and in the Cheng
Tsang Mun Chair Visiting Professorship at Singapore Management University. He has also been a visitor at
Peking (Beijing) University and the Swedish Institute for Financial Research and a distinguished visiting scholar
at Stanford Business School. He is an Honorary Professor at the City University of Hong Kong.

Professor Penman received a first-class honors degree in Commerce from the University of Queensland,
Australia, and M.B.A. and Ph.D. degrees from the University of Chicago. His research deals with the valuation
of equity and the role of accounting information in security analysis, and a number of his papers deal with
accounting policy issues. He has published widely in finance and accounting journals and has conducted seminars
on accounting and analysis for academic and professional audiences.

In 1991 Penman was awarded the Notable Contribution to Accounting Literature Award by the American
Accounting Association and the American Institute of Certified Public Accountants, and in 2002 was awarded
the American Accounting Association and Deloitte & Touche Wildman Medal for his book, Financial Statement
Analysis and Security Valuation, published by McGraw-Hill/Irwin and now in its 5th edition. In 1997 he was
awarded the Institute for Quantitative Investment Research (INQUIRE) Prize in the U.K. In 2005 he was awarded
the Geewax Terker & Co Prize in Investment Research, and in 2011 the Roger F. Murray prize from The Institute
for Quantitative Research in Finance (Q-Group). He has earned the Abacus best paper award twice. In 2009 he
received an honorary doctorate from the Stockholm School of Economics and, in 2015, was elected to the
Financial Economists Round Table. His book, Accounting for Value, was published by Columbia University Press
in January, 2011.

Stephen Penman is a founding editor of the Review of Accounting Studies and served as managing editor
from 2002-2006. He is on the advisory boards of Phoenician Capital and Boston Harbor Investment Management
and has served as an advisor to fundamental asset managers in the U.S., Europe, and China. He also serves on the
Board of Directors of UBS Financial Services Inc. Hedge Fund Solutions and is chair of its audit committee.

In 2019, Penman was elected to the Accounting Hall of Fame. In 2020, he was elected to the Australian
Accounting Hall of Fame.

More at: http://www8.gsb.columbia.edu/cbs-directory/detail/shp38

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