Research on Valuation and Financial Statement Analysis A Product Focus

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Research on Valuation and Financial Statement
AnalysisA Product Focus

• Stephen Penman
• Columbia University
• CKGSB-PKU-Tsinghua Accounting Summer Camp
• July 9 -11, 2007

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Program

• Accounting research What is it all about?
• Product design and research design accrual
  accounting and cash accounting
• Product design and research design product
  failure of a popular asset pricing model

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Session 1

• What is accounting research all about?

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A Product Focus

• Accounting is not a study of natural phenomena
• Accounting is man-made accounting is a question
  of design
• For performance measurement
• For internal decision making
• For financial reporting
• For valuation
• Accounting research is product oriented
  delivering a better product to the customer
• Delivery to the classroom and delivery to
  practice

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Features of a Good Product

• 1. The use of the product is well-defined the
  utilitarian criterion (with a notion of the
  customer)
• 2. Good products are based on good concepts
  from the theory of the underlying disciplines.
• Engineering from physics to bridges, airplanes
  and space vehicles
• Medicine from chemistry and physiology to cures
• 3. Good products have minimal side effects
• Good products work well against alternatives
• Traditional Chinese medicine versus western
  medicine

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An Analogy Drug Development

• What is the utilitarian problem we are trying to
  solve?
• What is the chemistry and physiology?
• What are the side effects?
• Does the drug improve outcomes relative to
  alternatives (placebos)?

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Two Types of Product Research

• Investigating the product features of existing
  products benefits and side effects
• --- price regressions in empirical
  research
• --- earnings management under GAAP
• --- transactions structuring under GAAP
• Designing new or alternative products
• --- fair value accounting vs. historical
  cost
• --- accounting-based valuation models
• --- new financial statement analysis products
• --- new accounting quality diagnostics

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Some New Products from Research

• From academic finance
• Capital Asset Pricing Model (CAPM)
• Black-Scholes option pricing model
• From academic accounting
• Bankruptcy prediction models (Z-score, O-Score)
• Activity Based Costing (ABC)
• Economic Value Added (EVA)
• Residual Earnings and Ohlson-Jeuttner (OJ)
  Valuation Models
• Active investment products Accrual Anomaly

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A Good Valuation Product?

• The Capital Asset Pricing Model
• Good Concepts?
• - Dont pay for diversifiable risk
• Normal return distributions
• Good Product?
• Measurement of beta
• Measurement of market risk premium
• Deceptively precise
• Can we design a better product? Three factor FF
  Model?

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A Good Financial Statement Analysis Product?

• The mean ROA from 1963-99 was 6.6
• The median ROA from 1963-99 was 6.8
• The mean annualized short-term Treasury yield was
  6.5
• A conceptual problem or a measurement problem?
• Can we build a better product?

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A Good Valuation Product?

• The Method of Comparables
• Concept No Arbitrage
• Good features Easy, uncomplicated
• Side effects Pyramid Schemes

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A Good Valuation Product?
Analysts consensus forecasts
Required return Risk-free rate 5 g
4 GDP growth rate
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A Brief History of Accounting Thought

• Up to 1930 Appeal to precedent
• 1930-1970 Normative accounting theory
• 1970 onwards The empirical revolution
• 1975 onwards Positive accounting theory
• Modern accounting theory

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Up to 1930 Appeal to Precedent

• A study of practice How is accounting done?
• Rule making codifies practice Generally Accepted
  Accounting Principles (GAAP)
• Not an analytical approach, not a normative
  approach
• Appeal to voluntary behavior Market solutions

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A Light Goes On

• A watershed monograph the structure of
• historical cost accounting
• Paton and Littleton monograph (1940), An
  Introduction to Corporate Accounting Standards
• Revenue recognition
• Matching
• An income concept, with balance sheet the
  residual
• Understand product features

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1930-1970 Normative accounting theory

• A priori analysis using authors own
  introspection This is what I think
• Very normative
• Developed alternatives to historical cost
  accounting
• - Replacement cost accounting
• - Current exit price accounting
• - Deprival value accounting

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1930-1970 Normative accounting theory (cont.)

• Limitations
• Numerous prescriptions, but no means of sorting
  them out other than appealing to aesthetics
• Not grounded in foundational disciplines
• The replacement cost experience FASB Statement
  33

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The Empirical Revolution Contemporaneous
Correlations

• Features
• Defer to the data
• Documents contemporaneous correlation with prices
• Information perspective vs. Measurement
  Perspective
• Examples (capital markets research)
• Ball and Brown (1968)
• Beaver (1970)
• Beaver, Financial Reporting An Accounting
  Revolution
• Limitations
• Informs on one product feature value relevance
• Assumes market efficiency
• Not normative Correlations cannot dictate policy
• No products! Earnings response coefficients?

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The Empirical Revolution Predictive Correlations

• Accounting numbers predict future prices
• - P/E and stock returns
• - Ou and Penman (1989) financial statement
• analysis
• - P/B and stock returns
• - Accrual anomaly
• Products (for better or worse)!
• - Active investment management products
• - Revised asset pricing models Fama and
  
• French

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A Light Goes On

• Beaver bankruptcy study, 1966
• Accounting ratios predict bankruptcy
• - Cash flow/debt
• - Net income/total assets
• - Total debt/total assets
• - Working capital/total assets
• - Current assets/current liabilities
• Accounting is useful!
• Focus on output products

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Positive Accounting Theory 1970 Onward

• Watts and Zimmerman
• Without regulation, accounting arises from
  voluntary contracts
• With regulation, accounting is the outcome of the
  political process
• Accounting boards trade-off constituents demands
• Accounting boards protect their own interests
• Limitations
• Cynical no design element
• But some reference to markets

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Modern Accounting Theory(Based on the
Foundations of Economics)

• Financial accounting theory
• Disclosure theory
• Agency theory
• Valuation theory
• Contribution
• - Good for ordering ones world
• Little help with policy issues or products
• Deals with information primitives rather than
  accounting
• An exception Valuation theory (Ohlson and
  Feltham and Ohlson)
• Connects accounting numbers to dividends and
  price
• Places accounting on the same foundations as
  finance MM
• Provides a representation of how accounting works
  for valuation
• Incorporates features of the accounting product

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Valuation Research the Starting Point

• The Dividend Discount Model (DDM)
• But it doesnt work! Why?
• Conceptual problems?
• The idea is non-controversial
• Practical Problems
• In the long run we are all dead!
• Practical considerations raise a conceptual issue
• For finite horizons, payout and payout
  uncertainty are irrelevant

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The Starting Point is a Product Issue

• Accounting-based valuation research begins with
  the recognition that the dividend discount model
  does not work.
• Forecasting dividends does not capture value
• 2. Dividends displace value rather than add to
  value
• An alternative valuation approach would
  accommodate these features

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A Product of Modern Finance DCF

• Does it work?

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Does DCF Work for Home Depot?

• Home Depot, Fiscal 1997-2001 (in millions of
  dollars)
• V ?
• Professor I have a terminal value problem!

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An Earnings Model (Gordon Model)

• It does not work for the savings account
• Required return 5 Earnings rate 5
  Reinvest so growth is 5

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The Residual Earnings Model
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Developing the Earnings Model

• (Ohlson and Juettner-Nauroth)

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Product Features

• Dividend displacement and dividend irrelevance
  if the accounting works properly
• Clean-surplus accounting for RE valuation
• Holds for all accounting that reconciles to
  dividends in the long-run
• Accounting otherwise not specified
• (The last two features leave us short cash
  accounting can work)

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A Valuation Model is not a Form but Rather a
Specification about How to do the Accounting

• Specify the Accounting for Book Value and
  Earnings
• Point of Departure Cash Accounting
• (If effective interest method is used and debt is
  market to market)
• This is the DCF model.
• See Lukke (1959), Feltham and Ohlson (1995), and
  Penman (1997)

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A Valuation Model is not a Form but Rather a
Specification about How to do the Accounting

• Alternative specification of the Accounting for
  Book Value and Earnings Accrual accounting
• This is the residual operating income model.
• But this is form, not substance the measurement
  of NOA and OI is not specified

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Two Ways to View Accounting

• Information that forecasts future payoffs
• capital markets research
• Specification of the payoffs to be forecasted
• A valuation model is a specification of an
  accounting
• system for the future.
• Current accounting involves realizations of
  expectations that are information about the
  future
• accounting.

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Another Issue

• The concept of future prospects and particularly
  of continued growth in the future invites the
  application of formulas out of higher mathematics
  to establish the present value of the favored
  issue. But the combination of precise formulas
  with highly imprecise assumptions can be used to
  establish, or justify, practically any value one
  wishes, however high.
• Benjamin Graham, The Intelligent Investor, 4th
  ed. pp. 315-317.

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A Good Valuation Product?
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Financial Statement Analysis Products

• (See Penman, Financial Statement Analysis and
  Security Valuation)
• Distinguish operating activities from financing
  activities (the accounting is different!)
• Tie accounting measures to Residual Earnings and
  Abnormal Earnings Growth (and thus to value)
• Carry out accounting for the future
• RNOA, not ROA

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Another Product Financial Reporting Policy

• Please go the web site for the Center for
  Excellence in Accounting and Security Analysis at
  Columbia Business School
• www.gsb.columbia.edu/ceasa

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Some Empirical Research

• On Dividend Displacement of Earnings
• Penman and Sougiannis (1997)
• On Comparative Accounting Systems
• Penman synthesis paper (RAST, 1997)
• Penman and Sougiannis (CAR, 1998)
• Francis, Olsson and Oswald (JAR, 2000)
• On Investing Using Accrual Accounting Models
• Frankel and Lee (1998)
• Lee, Myers and Swaminathon (1999)
• Arbarbanell and Bernard (2000)

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The Research(Continued)

• On Accounting Measurement
• Penman Sougiannis (1997)
• Beaver and Ryan (2000)
• On Financial Statement Analysis
• Nissim and Penman (2001a)
• Nissim and Penman (2001c)
• On Reverse Engineering
• Claus and Thomas (2001)
• Easton, Taylor, Shroff, and Sougiannis (2000)
• Gode and Mohanran (2003)

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References and Further Reading

• Abarbanell, J.S., and V.L. Bernard. (2000). Is
  the U.S. Stock Market Myopic? Journal of
  Accounting Research 38, 221-243.
• Beaver, W.H., and S.G. Ryan. (2000). Biases and
  Lags in Book Value and their Effects on the
  Ability of the Book-to-Market Ratio to Predict
  Book Return on Equity, Journal of Accounting
  Research 38, 127-148.
• Brief, R.P., and R.A. Lawson. (1992). The Role
  of the Accounting Rate of Return in Financial
  Statement Analysis. The Accounting Review 67,
  411-426.
• Claus, J.J., and J.K. Thomas. (2001). Equity
  Premium as Low as Three Percent? Evidence from
  Analysts Earnings Forecasts for Domestic and
  International Stocks. Journal of Finance
  Forthcoming.
• DeChow, P., A. AuHon, and R. Sloan. (1999). An
  Empirical Assessment of the Residual Income
  Valuation Model. Journal of Accounting and
  Economics 26, 1-34.

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References and Further Reading (Continued)

• Easton, P., G. Taylor, P. Shroff, and T.
  Sougiannis. (2000). Empirical Estimation of the
  Expected Rate of Return on a Portfolio of
  Stocks. Journal of Accounting Research
• Fairfield, P.M., and T. L. Yohn. (2001). Using
  Asset Turnover and Profit Margin to Forecast
  Changes in Profitability. Review of Accounting
  Studies.
• Feltham, G.A. and J. A. Ohlson. (1995).
  Valuation and Clean Surplus Accounting for
  Operating and Financial Activities. Contemporary
  Accounting Research 11, 689-731.
• Francis, J., P. Olsson, and D.R. Oswald. (2000).
  Comparing the Accuracy and the Explainability of
  Dividend, Free Cash Flow, and Abnormal Earnings
  Equity Value Estimates. Journal of Accounting
  Research 38, 45-70.
• Frankel, R. and C.M. C. Lee. (1998). Accounting
  Valuation, Market Expectation and Cross-Sectional
  Stock Returns. Journal of Accounting and
  Economics 25, 283-319.
• Gebhardt, W.R., C.M.C. Lee. And B. Swaminathan.
  (2000). Toward an Implied Cost of Capital.
  Journal of Accounting Research.

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References and Further Reading (Continued)

• Gode, D. and P. Mohanram. (2001). What Affects
  the Implied Cost of Equity Capital? Review of
  Accounting Studies
• Lee, C.M.C. Myers and B. Swaminathan. (1999).
  What Is the Intrinsic Value of the Dow? Journal
  of Finance 54, 1693-1741.
• Myers, J. N. (1999). Implementing Residual
  Income Valuation with Linear Information
  Dynamics. Accounting Review74, 1-28.
• Nissim, D. and S. Penman. (2001a). Ratio
  Analysis and Equity Valuation From Research to
  Practice. Review of Accounting Studies 6,
  109-154.
• Nissim, D., and S. Penman. (2001b). An Empirical
  Analysis of the Effect of Changed in Interest
  Rates on Accounting Rates of Return.
  Contemporary Accounting Research
• Nissim, D., and S. Penman. (2001c). Financial
  Statement Analysis of Leverage and How It Informs
  About Profitability and Price-to Book Ratios.
  Review of Accounting Studies
• Ohlson, J.A. (1995). Earnings, Book Values, and
  Dividends in Equity Valuation. Contemporary
  Accounting Research 11, 661-687.

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References and Further Reading (Continued)

• Ohlson, J.A., and B.E. Juetter-Nauroth. (2000).
  Expected EPS and EPS Growth as Determinants of
  Value. Review of Accounting Studies
• Penman, S. H.(1997). A Synthesis of Equity
  Valuation Techniques and the Terminal Value
  Calculation of the Dividend Discount Model.
  Review of Accounting Studies 2, 303-323.
• Penman, S. H. Financial Statement Analysis and
  Security Valuation, 3rd. Ed. (New York McGraw
  Hill). Second edition in Chinese.
• Penman, S. H. and T. Sougiannis. (1997). The
  Dividend Displacement Property and the
  Substitution of Anticipated Earnings for
  Dividends in Equity Valuation. Accounting Review
  72, 1-21.
• Penman, S. H. and T. Sougiannis. (1998). A
  Comparison of Dividend, Cash Flow, Earnings and
  Approaches to Equity Valuation. Contemporary
  Accounting Research 15, 343-383.
• Penman, S.H. and Y-J. Zhang. (2006). Accounting
  Conservatism, the Quality of Earnings, and Stock
  Returns. Working Paper, Columbia University and
  University of California, Berkeley.
• Sloan, R. (1998). Do Stock Prices Fully Reflect
  Information in Accruals and Cash Flows About
  Future Earnings? Accounting Review 71, 289-315.