This conversation is part of our “Wisdom in Books” series and podcast.
In this interview, Stephen Penman shares key insights from his new book, Financial Statement Analysis for Value Investing. As the George O. May Professor Emeritus at Columbia Business School, Penman offers a rigorous critique of conventional valuation tools, arguing that forecasting distant free cash flows for a traditional DCF model is often a “fool’s errand”. He challenges the core idea that valuation models are meant to find a single, elusive “intrinsic value,” a notion even Ben Graham found problematic.
Instead, Penman argues that valuation models should be used as a “way of thinking” to reverse engineer the market’s expectations. This approach, which he frames as “negotiating with Mr. Market”, forces the analyst to quantify the growth and margin assumptions already baked into the stock price.
The foundation of this analysis, he argues, is not cash accounting but accrual accounting. Penman makes a compelling case for why balance sheets and income statements — when properly scrutinized — provide a more reliable picture of value creation. He explains that accrual accounting “brings the future forward in time”, minimizing the reliance on highly speculative terminal values that plague cash-flow models.
The discussion also delves into the practical application of these ideas. Penman details how leverage distorts common metrics like ROE and P/E, stressing the need to separate operating from financing activities. He critiques the academic search for a single cost of capital, suggesting the hurdle rate is a personal, rather than an objective, number.
The conversation explores earnings quality, quantitative factor investing, and the importance of intellectual honesty in avoiding self-deception. Enjoy!
🎧 What You’ll Learn in This Masterclass
The New Book: Why this is an “active investing book,” not just a new edition.
The “Fool’s Errand”: A critique of traditional DCF and long-term forecasting.
Reverse Engineering: Using valuation models to understand the market’s thinking, not to find intrinsic value.
Accrual vs. Cash Flow: Why accrual accounting provides a more secure valuation and reduces reliance on terminal value.
Earnings Quality: Red flags to watch for, including gaps between earnings and cash flow.
Conservative Accounting: How to spot it and why “aggressively conservative” accounting can distort future profits.
Distortions from Leverage: How debt impacts ROE and P/E ratios and the importance of “unlevering” the analysis.
Rethinking Risk: Why the CAPM is flawed and the cost of capital is a “personal matter”.
Margin of Safety: How to apply the concept when you can’t pinpoint intrinsic value.
The “Too Hard” Pile: Valuing high-growth, non-profitable companies like AI and biotech startups.
Factor Investing: A critique of “data dredging” and trading on simple multiples.
Special Situations: Applying the framework to M&A and property-casualty insurers.
M&A Accounting: The problem with goodwill and intangible amortization.
The Future of Value Investing: Why the core principles remain, even with AI and new information sources.
The Investor’s Mindset: The personal attributes required for success, including discipline and avoiding self-deception.
The following transcript has been lightly edited for clarity.
John Mihaljevic: It is a great pleasure to welcome Stephen Penman, the George O. May Professor Emeritus and Special Lecturer at Columbia Business School. His books, Accounting for Value and Financial Statement Analysis for Value Investing, are truly volumes that should be on every intelligent investor’s desk and should be read carefully — because what I found is that they’re very applicable to actual investing, as opposed to a lot of accounting books that will teach you accounting but aren’t going to be as applicable to the craft of investing itself.
Stephen Penman: Yes, I think that’s right. We try to write the book in an active style, rather than just explaining investing, explaining accounting, valuation models, cookbook stuff. We put it in a very active investing style. If you want to be a fundamental value investor, here is how to approach it in an active way, and particularly with dealing with the accounting involved.
John: The new edition came out just some months ago here in 2025. What motivated you to write this new edition, to update your insights?
Stephen: Let me just correct you there. It’s not a new edition of a previous book. I have two previous books, one which is more of a textbook style called Financial Statement Analysis and Security Valuation. That’s been around for, 2001 was the first edition. That was published by McGraw Hill, who have decided not to proceed, as a textbook. They’re textbook publishers now into the big mass markets, so they didn’t want to proceed with a sixth edition. So this is instead of that. It flows on somewhat in terms of ideas from another book called Accounting for Value, also published by the, like this book, this new book, by the Columbia University Press.
But it’s not a continuation. It’s actually written much less a textbook in style, rather than an active investing book. Having said that, it is very much designed also for a textbook, in the style and the opinion that students being active about investing will grab students, not just gathering knowledge, but actually thinking about how to do this on a practical basis. So it’s also a textbook with a lot of additional materials on the website for professors and so on. I should say it’s not just my book either, it’s co-authored with Peter Pope, who’s a colleague also at Bocconi University. So it’s a joint effort here.
John: Terrific. Maybe just lay out some of the core messages, or topics that you sought to cover with the book.
Stephen: That’s going to be a long answer, but I’ll give you the one, some one-liners to help you along there. The book is about active value investing, fundamental investing as we say, but it’s about how to go about it.
When I think about value investing, as most value investors do, the first thing you think about is the business. What’s the business model? Where’s it going? What’s its strategy? How can I think about what the business is going to look like in one, two, three, four, five years ahead? That’s the most important aspect of value investing: first of all, understand the business.
But the book is not primarily about that, although it’s in the background there and refers back to it. It’s really about, then, once you understand the business, you think it’s a very good business, let’s get some quantification going to get it expressed in terms of numbers, dollar numbers, or euro numbers, whatever you want, which you can actually then employ to actually think about dollar or euro prices.
That’s the accounting. We call that accounting, pulling the information together, how you pull that information together in an efficient way to actually understand, you think it’s a good business, but I want to get an assessment of what it’s worth to understand whether actually the price at which it’s trading is the price to pay.
That’s of course all standard value investing, so there’s nothing new there. Where the book is innovative, and it is quite a different book, is in a number of ways.
The first way is, we don’t like valuation models, at least as they’re typically applied. The idea that you can forecast free cash flows for 5 years, 10 years, 20 years, discount the free cash flow value, and get a thing called intrinsic value, we think that’s rather a fool’s errand. Forecasting into the distant future is very, very difficult. The book has a wonderful quote that I took from Charlie Munger, Warren Buffett’s sidekick, or more than a sidekick, which he says, “the idea that you use valuation models to forecast the future, discount back, he says, that’s not the way to do it.” He says, he has a sentence there where he says, “That’s what they teach in business schools. Well, they’ve got to do something.”
So it actually says valuation models are really not for valuation. Valuation models are a way of thinking about valuation, to direct your thinking. And in doing that, it differs from the standard way of doing, which is discounted cash flow analysis, which we call cash accounting. It uses balance sheets and income statements. The rough model that outlines this is the residual income model, where you think about the balance sheet and adding value to the balance sheet. But it doesn’t plug in discount rates and growth rates and pretend you’re getting the intrinsic value.
In fact, we say in the book, it’s probably best to think that you cannot find the intrinsic value. It’s a very elusive notion. Benjamin Graham actually said that many, many years ago. It’s a very elusive notion.
So what we do is we adopt the approach which goes back to Rappaport and Mauboussin way back, the reverse engineering approach. We do it a little differently from them. We say, here’s the price that the market is asking you to pay today for Nvidia, for Microsoft, for any of them. Do I want to buy? Or do I want to sell?
And then, to begin a process by saying, to answer that question, I don’t go independently and try and find an intrinsic value and use a valuation model which has very doubtful inputs. What is the growth rate you’re putting in, the long-term growth rate? It’s very hard to get hold of.
So, we say, let me understand the thinking in the market price. And so it uses the valuation model to understand the thinking in the market price. This is, again, a very traditional approach in value investing. Benjamin Graham, if you go back to Security Analysis, if you go back to his books, he talks about investing as being a matter of negotiating with Mr. Market. “What do you think about it, Mr. Market? And how does that compare with how I think about it?” First, you’ve got to understand, you’ve got to understand what is his thinking.
And so that’s the approach taken. And once you understand his thinking, and using it to understand the big thing is understanding his estimation of growth in the future, then you can start your fundamental analysis by then pulling your accounting together, pulling your analysis together, doing your fundamental analysis. “He thinks that there’s likely to be a growth rate of 7%. Can I actually, knowing the business, can I actually think, yes, that’s reasonable? Because I think that the sales implied in that, the margins implied in that, are actually reasonable.” Or otherwise. And so that’s the way to approach the task.
Other themes in the book, there’s a standard theme: valuations are a matter of accounting. One accounts for value. And how you do that accounting in challenging the market price, in challenging Mr. Market’s estimate of the future, is an accounting matter. And how you do the accounting is, valuation is a matter of accounting for the value. That requires, of course, you understand accounting, but it also requires that you actually use good accounting.
So there’s a couple of chapters, more than a couple of chapters, that deal with, “If I want to use US GAAP accounting or IFRS accounting, is that good accounting?” A lot of it’s good, but here’s some things you have to watch out for. And so it instructs about how you actually do your accounting in a way with integrity that gets you on to make you secure and get you on to proper foundations. I can go on, there are many other themes, but...
John: Let’s just get into some specifics here, perhaps on the topic of earnings quality. A lot of value investors swear by cash flows, but accrual accounting could also reveal value creation, maybe even more reliably. I’m wondering if you could talk a little bit about accrual earnings, following the realization principle, and using them versus raw cash flow.
Stephen: That’s really to the point of accounting for value. Discounted cash flow analysis, using cash flows, free cash flows, is, it’s cash accounting. It’s what’s going through the cash flow statement. And as you say, accrual accounting says, “No, the focus is going to be on balance sheets and income statements. The investments you put in place and what they’re going to earn, to cover your cost of capital.”
Then it goes, it says, “Why would you want to do this?” There are a few reasons. First of all, discounted cash flow analysis forecasts free cash flows. Free cash flows are cash flows from operations—we like that stuff, cash, net cash coming in—minus investment. That’s the free cash flow after you reinvest in the firm.
From an accounting point of view, that’s rather strange, that investment is treated as a bad. Cash flow from operations minus cash investment. So the more you invest—and growth companies invest a lot—the lower your free cash flows. Ultimately that investment will turn back and generate positive cash in the future, but in the long term, we’re all dead. Forecasting what’s going to happen in the long term is very difficult. Forecasting more than 3, 4, 5, 6 years gives me severe psychological problems.
Accrual accounting says, “Hold it. Hold it. We’re not going to treat those investments as a bad. We’re going to generate a balance sheet. And we’re going to put those on the balance sheet.” We don’t do that with all assets, we don’t do that with all investments. We don’t do that with R&D, so there’s an issue.
Then, it says, “Look, when we recognize the earnings in doing that, recognize the earnings, we’ve got to use accrual accounting.” So if you’re using discounted cash flow analysis, forecasting cash flows, and you’ve got a pension scheme where the cash flows won’t happen until 30 years hence when the employees retire, that gives you a hell of a forecasting problem. Whereas the accrual accounting says, “Hold it, we’ll do this for you. We’ll actually recognize the liability to do that on the balance sheet. So it’s there already, booked for you. You don’t have to forecast it for the very long term. And at the same time, we’ll recognize the associated wages expense committed this period from actually making these promises to employees.”
That’s the way, in some sense, what it does is it brings the future forward in time. So you’re not stuck with this big problem of forecasting for the very long term or developing a valuation which rides on a terminal value, where the terminal value is a very high proportion of the—the terminal value which deals about speculation in the long term is typically, even for a mature company, is actually usually very high proportion of price. Starbucks, which is now a very regular company, if you try to value that, 90% of the valuation is in the terminal value, and you’ve got to come up with a growth rate and plug it in, and that one’s a tough one.
We want to avoid that. So we want to get to a situation where there’s more reliance on what you see now, the earnings and the book values, and maybe the near-term earnings that you can get a grasp on, and then, without that reliance on that long-term, minimize the long-term. And accrual accounting does that for you because it brings the future forward in time and gives you a more secure valuation.
John: Accrual earnings can be manipulated. Even cash flows can, for that matter. But what red flags or quality checks do you recommend investors look for in financial statements to guard against aggressive accounting? For instance, are there particular signs such as unsustainably high accruals, one-time gains, or big gaps between earnings and cash flow that would signal that earnings may not be actually translating into genuine value?
Stephen: You’re right. That there’s the rub, as we say. Yes, accrual accounting in principle, gives us a better recognition, better grasp on the value generation. However, many accruals, most accruals, are subject to estimates, and so there you have some issues.
We do have institutions to deal with that. We have auditors. We have audit committees. We have boards of directors. We have the SEC sitting there, which are some protection, but of course, these sometimes fail us. So the book then says, “Here,” there’s a couple of chapters there, it says, “Here is what you’ve got to watch out for. And here are the diagnostics to actually assess whether the accruals are good quality or not.”
Yes, the accruals versus the cash flow is one of them. If you’re putting high receivables and you’re getting little cash from your customers, you better go and check that one out. It points out also the balance sheets and income statements are, balance sheets as well as income statements are important for the quality of the accounting.
So, the way we think about the balance sheet, as a quality balance sheet, is one that cannot come back and hit you later. If you look at the residual income model, which is the basic framework here, the balance sheet goes into price one-to-one, there’s no discount for it. There’s a discount for the risk of future earnings, but not to the balance sheet. So that tells you the balance sheet has to be a safe balance sheet, a safe anchor. There’s nothing there that can come back and hit you later.
So, what can go wrong? Up to a couple of years ago, operating leases weren’t on the balance sheet. That’s going to come back and hit you later. At last, they’ve got that straight. Fair value accounting, let’s watch out for that. If they’re writing up assets and they’re recognizing things at fair value, unrealized—you mentioned the realization principle—it’s unrealized, it’s still at risk. Risk is only resolved when the asset value is realized. Off-balance sheet liabilities, leases are the example. The off-balance sheet liability for contingent equity securities, for convertible bonds.
The trick there of issuing convertible bonds, recording them at face value, and having very low or no interest on the bonds, with all the cost to the shareholders coming on a generous conversion, where the accounting doesn’t record that cost to the shareholders, that’s something that’s going to come and hit you later, because when those shareholders, when those holders of the convertible bonds or preferreds exercise, they’re going to dilute your equity. So, these are accounting issues that have to be dealt with. That’s the balance sheet.
The income statement, a quality income statement is one that, there’s nothing in the income statement that can reverse later. Under-booking allowance for bad debts or over-booking revenues has to come back and hit you later. A quality income statement is one where if, in fact, the firm is going to be exactly the same next year as this year, the reported income here now is the income you’re going to get. There’s nothing there that’s actually going to affect you. And so there’s a lot of diagnostics on that. There’s a lot of diagnostics for sales, a lot of diagnostics for warranties, a lot of diagnostics for depreciation, and so on and so forth. And so the analysis is always done with these diagnostics.
Having said that, typically GAAP, US GAAP and IFRS, is pretty good accounting with some exceptions that are pointed out in the book. Most times, everything looks okay. Or most looks okay. But it’s very important to actually understand that in your fundamental analysis, you’re anchoring on really safe accounting.
One aspect of it is, and I really believe this, you mentioned the realization principle. Yes, let’s have the realization principle. Don’t book earnings until you get a customer. Fair value accounting goes against that, of course. In fact, that’s the whole part of the history of value investing. Back in the 1920s, firms routinely wrote up assets because it was boom time. “The assets are worth much more than the accountants have on the books. We’ve got to write them up.” And then one day in October 1929, the asset values crashed.
That was the beginning of Benjamin Graham’s insight. John Maynard Keynes also, who lost a lot of money in the 1920s, he became a value investor. And what they demanded is, “No more water in the balance sheet.” You put water in the balance sheet, it can evaporate, as indeed fair values did in the global financial crisis in a lot of financial institutions, with the taxpayers left on the hook.
The demand, “Let’s stick to the realization principle. Don’t recognize value until it’s everything’s safe.” That also tells you, if it’s not recognized yet, you and I as an investor, we can anticipate that and put it into our price. Just realize that revenues and earnings not yet recognized are still at risk. You might want to think about that.
John: We often want to find the red flags, but if we wanted to actually identify businesses that are conservative in their accounting, what would we look for or what are the usual ways that managements can be very conservative and still stay within what’s allowed by GAAP?
Stephen: GAAP itself is very conservative, actually, until you got into the movement towards fair value accounting, which the regulations, both the SEC and the standard-setting boards, have withdrawn from. They’re basically only applying it to certain marketable securities and derivatives. Just be assured that the basic accounting is conservative.
But then you have to look for those firms within that, within GAAP, that are being more conservative. They have a lot of conservative allowances for loan losses, in banks. They have conservative depreciation, which writes off assets quicker and gives you lower profits.
You recognize these firms as being conservative. That’s nice, but the opposite side of conservatism is, if you’re conservative now, you’re going to be less conservative later. So if you have high depreciation now, it means the asset is going to be fully depreciated before they’re actually economically depreciated. You’re going to have higher earnings in the future. So, conservatism, excessive conservatism, is sometimes bad.
Basic conservatism is, “I want to be conservative. Yes, if in fact, I’ve got receivables, I want to make sure I discount them conservatively and not get in the situation where I’m overestimating the profits.” But I can be too conservative, too. I can be aggressively conservative, if you wish. And that’s got to be looked at also, because that means that they’re written things down.
Impairments are a very good example, when firms take impairments. They often do excessive impairments, big baths. That’s, that often happens when there’s new management in. “We’re going to change the strategy. We’re going to write down.” They write down excessively. They write down assets, which means there’s less expenses from those assets, from the inventory written down, from the plant written down, to give you higher profits in the future. This is, I wouldn’t say as bad as going the other way and being aggressive on the upside, but it’s something that has to be watched.
Fortunately, some years ago, the FASB, required firms, after excessive write-downs in the 1990s and early 2000s, required firms to have much more documentation to support their write-downs.
John: That’s a great point, because when a business writes down too much, it’s basically inflating its future return on equity metrics in a way, which is not...
Stephen: It is. Yes, and it’s actually recognizing a liability for the estimated restructuring, and this liability is something that never has to be paid, so you have to actually bleed it back into earnings to get rid of the liability. That’s the impairment bleed-backs, which increase future earnings. IBM was very good at this in the 1990s. They looked very good. And actually, in the 1990s, they were a great company, no complaints. But actually, they excessively impaired in the early 90s, and that really increased their profits subsequently.
John: Let’s talk a little bit about leverage and risk in valuation. Your residual operating income model addresses the distortion that leverage can introduce to ROE and other metrics. Tell us just a little bit about how you address leverage.
Stephen: First of all, of course, we, as value investors, understand leverage is risky. And most people understand leverage is risky. Just ask the shareholders at Lehman Brothers. They know it’s risky. And they suffered because of it. And it’s very much in the theory, finance theory, that leverage is risky.
One of the rough rules of value investors is, “Just watch you’re not buying too much leverage.” Particularly if the operations are risky. But there’s a more subtle point, you referred to, is that leverage affects a lot of the accounting measures that we typically use. So return on equity, for example, which we take as a measure of profitability for the shareholders. Leverage, increase leverage, increases the return on equity. But in theory, generally, it doesn’t increase value. You issue bonds at the market price, fair value, it doesn’t, it doesn’t change, it doesn’t add value. Just trading bonds doesn’t add value, unless of course you’re an arbitrageur, a bond trader.
It increases ROE. You’re on the board of directors, and the CEO comes to you and says, “I think my compensation should be based on return on equity, return to the shareholders.” And you say, “That sounds good. Let’s go for that.” It’s a big mistake, because just tomorrow, you’re going to get a bond issue, financing a stock repurchase, to change the equity, lever it, and the ROE is going to go up tremendously, but no value has been added.
It’s not just ROE that’s affected. P/E ratios, which we look at, very, one of the most common metrics, the P/E ratio, is affected by leverage. I tend to ask my students when I introduce P/E ratios, “If a firm issues debt, what happens to the P/E ratio? Does it go up or go down?” They don’t know, of course, but their guess is it goes up. The answer is wrong, it goes down. More leverage gives you a lower P/E ratio. The book takes you through it, it’s deterministic, it’s just how accounting works and prices work.
If you screen on P/E ratios and you look at a low P/E ratio, say, “That’s a low, that’s a low-priced stock, I’ll go and buy it.” If it’s due to leverage, then you’re just loading up on risk.
There are many other metrics in accounting. Price-to-book ratios are affected by leverage. They tend to be higher the higher the leverage. The price looks high relative to book value, but it’s only a function of the leverage.
So, you said it. Whenever you do valuation, you’ve got to unlever. Get rid of the leverage. Work with the operations, the operating activities. And this is a basic distinction in finance, of course. This is Modigliani and Miller. Leverage, except in special circumstances, leverage doesn’t affect the price of the equity. Get rid of it. And understand the, the added value comes from the business activities, the operating activities.
And so look at return on the net operating assets, look at unlevered earnings-to-price ratios, look at unlevered rates of return, and so on and so forth. And carry out everything on an unlevered basis.
As it turns out, the leverage is pretty much clear already from the financial statements. Debt assets and debt liabilities typically are very close to value. Unless there’s been a big change in creditworthiness or interest rates and so on. So the debt seems to be reasonably priced. It’s the pricing of the business that’s the important thing. And to do that, you’ve got to make sure, a very fundamental rule in value investing is, in accounting analysis and financial statement analysis, separate the financial activities from the operating activities. Don’t get them mixed up.
Yes, there’s debt there, there are, there may be a large amount of debt assets, like capital. Any shmuck can buy a bond. Any shmuck can buy a CD. That’s not where your value comes from. So that is the focus. And that gets over the mistake you can make by looking at levered accounting numbers.
John: When it gets particularly interesting is when the leverage is not your plain vanilla, straight-up leverage, but let’s say non-recourse leverage of some sort where the equity has the upside but limited downside. And then in that case, maybe it would make sense to give the equity some credit for that non-recourse leverage, given the asymmetry. How would we do that?
Stephen: I think it depends on what, in terms of generating the instrument, what you paid for it. If it’s fair value that reflected all these things, it’s going to be okay.
The case where leverage, where looking at the debt is going to be important is, in fact, when the financing transactions are not done at fair value. So, if in fact, you issue bonds and take the proceeds and buy back stock, because you think your stock is under-priced, that’s going to generate value. So any trade, or if, in fact, you think, “My bond’s mispriced,” so it’s time to actually go and do that. This is the, this is the trick of firms in the times when the Fed puts interest rates low and interest rates are very low. You’ve got very good credit ratings. You go out and issue some bonds, take advantage of that low interest rate. That generates some value. This is bond, this is actually bond arbitrage.
But if you’re issuing bonds and you’re issuing equity or repurchasing equity at fair market value, then that’s, that can’t create value. That’s a theorem in finance. But the alternative, the contrary situation, of course, is, yes, you do stock repurchases when you think your stock is under-priced. And be careful not to issue stock when you think it’s under-priced.
There’s a model there for actually gaining money from leverage. There’s another aspect to it. There’s a whole chapter on leverage. But there’s another aspect to it is, value investors say, “Be careful of leverage, don’t buy any leverage.” But there’s a time when, in fact, you might want to lever up because you’re so convinced that the stock is cheap. In trading terms, there’s alpha there. That then you might want to lever that up. You might want to go and borrow and lever that up.
That’s very risky. You’ve got to be very, very sure of your position and a real good margin of safety. You might want to lever that up. And that’s in an unlevered active investing fund, of course. But also, you might, if you’ve got two firms that are both equally attractive, and you want to invest in them, the one that has higher leverage is actually going to be more attractive because their leverage is going to give you, their leverage, the firm’s leverage, is going to give you a higher return when, in fact, it all pays off.
So the firm can, you can go into debt on private account, or the firm can go in debt on the shareholders’ benefit. Just as you can buy a cheap stock when you think it’s under-priced, but the firm also can buy back their own stock when it’s under-priced on your behalf. The benefit accrues to the shareholders. And so the analysis goes through. These are exceptions. The best place to start is there’s no value added from debt. That is the starting point. And then you look at these situations where there might be, in which case you can do some debt arbitrage.
John: And also, the tax code is another potential factor where maybe it favors some degree of leverage.
Stephen: Yes. You’ve got it. That is not recognized in the accounting. So if, in fact, you issue debt and you get a tax deduction for the debt, which is now more limited than it used to be, you get tax, then there’s a subsidy for the debt. That is potentially there.
But you do have to watch out. The firm issues debt to get the tax benefit. They’ve got to sell it to someone. Let’s say you or me. We have to pay taxes on the interest. So we might price that in. So it works both ways. It’s not automatic that you actually get the tax benefit of interest deduction as a corporation, because you actually then have to put the stuff on other people who actually have to pay tax on the interest income they receive. Who don’t get the subsidy. And that’s going to be built into the price. That’s a pretty thorny problem, actually, working that through. But it’s not automatic that, in fact, that the tax deduction is a subsidy that flows directly to the shareholders.
John: Thank you for that insight.
Stephen: That insight is not mine. That’s actually Merton Miller, who was on the original Modigliani and Miller, which talked about the tax benefit of debt. And then he came back in a later paper in, I think, 1977 and said, “Oh, hold it. I’m not sure I’m quite right on that.”
John: (Laughs) Right. Now, when it comes to accounting for risk in valuation, the traditional finance model would take a risk-adjusted discount rate, I guess with beta in there. You advocate for a slightly different approach. Could you talk a little bit about that, please?
Stephen: Yes, I do. We do in the book. And I wouldn’t call it slightly; I’d call it quite a different approach.
John: I was being diplomatic.
Stephen: (Laughs) Yes, who’s listening? Right. No, it’s very easy to take a model like the Capital Asset Pricing Model and say, “Oh, this gives me the discount rate. I’ll just plug it in and go for it.” But as Charlie Munger said, “You’ve got to be worried about all models.”
Let me start with the story, which I think is in the book.
In the Global Financial Crisis of 2008-2009, I was teaching a valuation class. Warren Buffett wrote a paper in the New York Times saying the S&P 500 had crashed. It dropped down to as low as 667, I think, at one point. This is about November 2008. He wrote a piece in the New York Times saying, “Now’s the time to buy stocks. They’re cheap.”
So I grabbed the New York Times, I walked in the class—I waddled into class—and I said, “Hey, look, it’s time to buy stocks. Are you guys buying stocks?”
And the students... no one said yes. And I said, “Well, why aren’t you buying stocks?”
“Well, Professor, we’ve just had this huge crash. We are finance graduates, investment graduates. Columbia is basically a finance school, more so in those days. We don’t think we’re going to get a job. The whole world’s going to hell. We’ve got a lot of risk. Not only that, we’ve got student debt to the ceiling. We’re very highly levered. We just cannot take the risk.”
It was a very uncertain world. “What’s going to happen?” If you can remember back to November 2008, my goodness, is this the end of the world?
So they’re basically saying, “I’m not buying stocks because my discount rate is infinite. It’s very high.”
Then they turned on me and said, “Hey, Professor, are you buying stocks?”
And I said, “Yes, I am, actually. I’m looking very closely at them all. But you’ve got to remember, first of all, I have a job. I’m not looking for a job. And Columbia University is silly enough to give me tenure. I cannot be fired unless I’m very, very naughty. I’m in a very secure situation. I’m not highly levered. So yes, it’s time for me. You and everyone else are running from stocks because of the risk. But for me, and also Warren Buffett, it’s an opportunity.”
Another thing he’s saying is, “We have a different discount rate. We have a different cost of capital. We have a different hurdle rate. We have a different hurdle rate compensation for risk.”
The first thing to recognize as a value investor is it’s a very personal matter. You have one that’s probably different from mine.
The second thing is to recognize that adopting a model that gives you the cost of capital is really a fool’s errand. We talked about “there’s no such thing as an intrinsic value.” It’s good to think there’s no such thing as intrinsic value. To think that there’s no such thing as a cost of capital that you can discover is probably a good way of thinking, too.
You think about the risk that firms face, except for your lemonade stand. There’s a complexity of risk, particularly for international firms. There are huge risks they face, varied risks. To think that you can funnel all those risks down into one number. “Hey, John, it’s 8.1%. It’s not 8.6%.” I think that’s a fool’s errand.
And they say, “Oh, well, but these academics have given us these pricing models.” One is the Capital Asset Pricing Model. Actually, that was quite a revolution in terms of thinking. That a lot of risk just comes from the sensitivity of the market portfolio, because you can get diversification through Markowitz. It was very good thinking. But then to have a model that says, “Now I can use this thinking to tell you, John, it’s 8.1%. It’s not 8.6%.” I don’t think so.
When you look at it, you start with the risk-free rate. Well, what do we use for that? We say in class, “Well, use the U.S. 10-year bond rate. Because the U.S. government has never defaulted.” Although, by the way, we’re getting a little worried about that now. But it’s not risk-free.
When the 10-year rate was below 1% at one time, you needed your mind read with all the money that was being printed to think that this was actually going to be the rate all the way through for 10 years. You’re going to get inflation. And inflation devalues your bond. It’s not risk-free, to be totally honest.
One thing we as value investors try to be, is to be honest. Honest in our way we conduct ourselves, but honest in our thinking.
Then it says, “To get the CAPM cost of capital, you’ve got to have a risk premium: the expected return on the market in the future minus the risk-free rate.” The expected return on the market? Man, if you give me that number, you’re a better man or woman than I am.
What do they do? You ask anyone, you ask the students. What is it? “It’s 5% or it’s 5.5%.” Why? “Because that’s what they teach in business school. Just use 5%. And don’t ask me about it.”
The beta’s estimated with a standard error of 0.2. So the whole thing’s very, very messy. You know from a valuation model, if you change that discount rate by just half a percent, you get very different valuations, particularly if it’s combined with a growth rate you don’t know much about.
Again, in the spirit of being honest, value investors have this creed: “Understand what you know and what you don’t know, and don’t base your valuation or your assessment on what you don’t know.” Admit that to yourself, and then think how to proceed.
The way we proceed in the book, it says, “You cannot expect the model to bail you out and say, ‘Hey, this is what I got in finance 120 course.’ No, you’ve got to go and make a business assessment of the risk. Pro forma it out on different scenarios. What’s the probability of getting this amount of sales, this amount of sales at these profit margins? Let me get the distribution.”
I can tell you in fundamental analysis, we can tell you by doing that, what the risk is, in pro forma. I can’t tell you how to map that into a number. “John, it’s 8.1%. Don’t tell me it’s 8.6%.”
Once you’ve done that, then you apply your own hurdle rate, and yours may be different from mine. I think that’s being honest about it. We just don’t know it.
It’s a dirty little secret, actually, in academia. We’ve been chasing the cost of capital, the discount rate, for, well, ever since Markowitz—80 years. Five Nobel Prizes for the effort. But the dirty little secret is we just don’t know how to calculate the cost of capital.
John: Very interesting. How should we rethink the concept of margin of safety if pinpointing an exact intrinsic value is problematic?
Stephen: That’s in the value investing creed, of course. Getting back to my notion of negotiating with Mr. Market. Here’s your price. I can do some accounting for value to give you an indication that will indicate to me what your growth rate is. To do that, I have to put in a hurdle rate, which has got to be my own hurdle rate.
However, one way of doing the margin of safety is, “If I put in a higher hurdle rate—something that I think I’d be satisfied in this environment of getting 10%, but if I put in 12% or 13%—what comes out of it is a number that tells you the market’s anticipating higher growth.” That actually makes sense, because if you have a higher discount rate, hurdle rate, you’ve got to have more growth to cover the hurdle.
If, in fact, once you’ve done your fundamental analysis and you see that Mr. Market’s assessment is very pessimistic relative to that high hurdle rate, you have a margin of safety. Use it not as something you know the hurdle rate, but use it as a tool to give you a margin of safety.
That’s one way of thinking about it. The other way to think about it: once I do this fundamental analysis and see how far I am from Mr. Market’s assessment, then let me go for the stocks where I think, indeed, there’s a margin of safety. He’s really quite wrong. Or let me avoid those stocks where I think he’s really overpriced, or short-sell them if you’re into that game.
John: On the topic of growth and value and paying for the future, I guess the basic message is that we should not pay, or certainly overpay, for growth. How does your framework help us think about companies that aren’t really generating any profits at the moment? Basically, every AI company out there, except for NVIDIA, is not generating profits at the moment. It seems highly uncertain what the future will look like for those new business models. Can we even begin to come to any intelligent assessment of value, or does that have to go into the “too hard” pile?
Stephen: The short answer is the “too hard” pile, but let me elaborate. You’re right. One of the themes of the book is the heart of investment is buying growth. Growth, because it’s growth in future earnings which are not yet realized, means those earnings are still at risk. Growth is risky. So if you have a lot of growth that you’re buying, you assess you’re buying a lot of growth in the market price, you might want to think this is a more risky firm. That’s a good way to think about it.
Now you get to a mature firm. I’ve got a history of sales and profit margins. I know the business. I can model it out with a fair degree of comfort.
But you get a firm where it’s all in the distant future. Those firms, as you say, are not making profits now.
I remember my students asked me many times when I was teaching at Berkeley during the dot-com boom. I was teaching financial statements. They said, “Professor, how do I value a Silicon Valley startup? How do I value a biotech startup?”
I have to say to you, this is just something that I cannot tell you about. Look at the balance sheet. All you’ve got is cash and cash burn. Look at the income statement. All you’ve got is expensed R&D, no revenues as yet, very little revenues as yet. I can’t tell you much at all. Here’s a good clue. Why don’t you go out and get a PhD in biochemistry and understand the science there?
This sort of analysis that we’re talking about here is not for those companies. But one thing I can tell you is that if you want to pay something for one of these companies, you must have a scenario where in the future, sometime in the future, this is going to bang. They’re going to get through phase three. It’s a very good drug, and so on and so forth.
You can model that out. But first of all, you’ve got to understand the biochemistry. That’s the primary thing. Doing financial statement analysis is not the name of the game. But I can tell you, you have to have that in the future.
If it’s a long time in the future, it’s growth. More so, if it’s growth a long time in the future, it’s going to be a long time before you’re going to get those earnings. You’ve got to recognize that that’s a very risky company. You might want to have a very high hurdle rate. It’s like a venture capitalist. What are their hurdle rates? 25%, 30%? Even if they do it that way, it’s got to be high.
I think that’s, again, a matter of being realistic. To pretend you can value a biotech startup with some analysis of accounting data is misdirected.
John: Quantitative strategies and factor investing have become quite popular. You seem to bring a critique to the idea of trading on simple multiples or smart beta schemes. What do those quant approaches miss, in your view, that an old-fashioned fundamental analysis can catch?
Stephen: You mentioned two things there. Let me deal with the latter one: trading on multiples. That is pretty easy. You look at the price, you can look up the book value or the earnings, get a P/E ratio, or price-to-book ratio, or price-to-sales ratio. As long as you can do division—you have to get at least to fifth grade—then you can do it.
You buy the ones that are low. Now, sometimes that works, but it’s a hell of a risk.
There’s a motto, again, we emphasize in the book, a tenet we emphasize in the book: “Ignore information at your peril.” Trading on just one bit of information, earnings; one bit of information, book value; two bits of information, earnings and book value—you’ve got to be very, very careful. You are in danger of trading with someone who’s really done their homework.
Here in this book, we teach how you do your homework. We’re going to try and do it parsimoniously so you don’t have to have thousands of bits of information. But you’ve got to do your homework. In some sense, the book is about what you’re missing out on, the mistakes you’re making when you do those quick-cut analyses.
They call it trading on P/E ratios, price-to-book ratios, “value versus growth” investments, for low P/Es and high P/Es and low price-to-books. It’s silly. All investing is value investing. You can buy a very high P/E ratio as a good deal.
That’s a very important point. The question, therefore, is what else do you need to pull in to actually get you a better trading strategy and to reduce the risk that you’re not trading against someone who’s done their homework.
You mentioned factor investing. I’ve read some time ago, there’s about $1 trillion under management of factor investing in the world. A lot of these factors, the very famous ones, of course, are the Fama and French factors. And the multi-factor model. “Well, the CAPM model, we see that doesn’t work. So let’s add some other factors.”
“How do we get these factors?” “We purely get them by data dredging.”
We go and see, “Oh, price-to-book predicts returns. We’ll make a factor out of that.” “Firm size predicts returns. We’ll make a factor out of that.” “ROE predicts returns. We’ll make a factor out of that.”
These factors are formed in the Fama and French five-factor, six-factor models, just simply by data dredging. There’s no theory, no understanding. Interestingly enough, they come up with accounting numbers. When you do your fundamental analysis, you understand the accounting, you understand what they’re picking up and what they’re not picking up.
In my mind, it’s a very crude approach, basically based on data dredging and not understanding the accounting. When that happens, you can run into trouble.
It turns out, I’m glad you asked this question, because what I’ve been involved in the last couple of years is research developing an accounting-based factor model, which understands the risk that’s conveyed by the accounting and building factors by the risk that the accounting is conveying.
You have a realization principle, it’s very important. “Yes, the price is high, but it’s not yet realized.” “What’s the probability that it’s going to be realized?”
I’m a bit dismayed, as I think most value investors are, about the cheapness of a lot of strategies. There are many good strategies out there, I’m sure, particularly on the buy side. We don’t observe many of them. They’re in the dark. There are many, many good strategies. There are many good fundamental strategies. There are many good quantitative strategies.
But in terms of the ones that publish, the Morningstar style box, my goodness, it’s very crude. It’s very crude. The key is, yes, you can throw the asparagus at everything. But what can you put on the table? That’s what we try to put on the table. But in doing so, we try to show what errors you can run into if you don’t get fundamental.
John: Certainly, it seems that often the tail wags the dog, or the marketing will drive the financial product that’s created and sold. It may not make the most sense from an accounting valuation standpoint.
Stephen: No, no. When you think of our industry, our finance business, which has had a lot of achievements, particularly in terms of risk-sharing instruments and so on. In some sense, it’s an industry that’s chasing AUM. Any way of getting AUM through marketing, through any device and so on, is important. If you have one good year, you display your returns.
It’s an industry which is getting in the more naive retail investor, because the retail investor doesn’t know about it, needs someone else for help. It’s all about chasing AUM, and there’s a basic notion that on average, funds don’t end better than investing in the index.
Which has given rise to this passive investing, which is a bit worrying if everyone’s a passive investor and no one’s doing the research. Then we’ve got a real random walk down Wall Street, haven’t we?
John: Absolutely. You have a chapter on special situations, which for value investors have been a mainstay ever since Joel Greenblatt’s book or even before that. Tell us what you mean by special situation in the context of financial statement analysis and a quick overview of how your approach can be applied in cases like turnarounds, restructurings, or other non-standard scenarios.
Stephen: Yes, the special situations are those particular situations. You mentioned turnarounds and restructurings. We don’t cover that there. In the chapter, we only cover two things. One is insurance: property-casualty insurers. The other is acquisitions, M&A.
It’s how to actually do the valuation in an insurer, a property-casualty insurer. The drivers are very, very different. The idea of the float, generating the float, and earning money from the float by investing that float in other assets, in other businesses like Berkshire Hathaway does, like Markel does, or buying securities. The cost of getting a float is, of course, lower premiums, which gives you a higher combined ratio, the loss ratio.
That’s what’s going on. It’s all within the same model. Work with the income statements and balance sheets. Understand the float from the balance sheet and how that float can change over time. And the income statement about how much the cost of getting the float—which is actually the loss or the slight profit you’re earning on the insurance side—is being earned.
On M&A, it’s a question of applying the same principles of the book to buying another company and how you might do that. In particular, how you split the value from an acquisition with the so-called added values, how that’s split between the target firm and the acquiring firm.
There are a lot of difficulties there. There are accounting difficulties. The accounting for acquisitions is bad. Here’s one example. What’s this goodwill number? It’s a plug. We’re supposed to impair it. What the hell’s in it?
I have done some work to generate an alternative accounting for goodwill and for acquisitions that gets to the heart of what’s being generated and what’s there to be impaired or otherwise maintained on the balance sheet.
Those are the two we look at. There’s a case there on restructurings, Coca-Cola’s restructuring, a number of restructurings at one time. It had the 49% equity in the bottlers, the 49% solution. Then it decided to acquire the bottlers. And now recently, in the last few years, it’s decided to offload those bottlers and distribution companies. There’s a restructuring going on. How do you think about the value generated in the restructuring? That’s not in the chapter; that’s in a case that goes along with the book.
John: What I’ve always found interesting when it comes to M&A is how automatic it is that investors exclude intangibles amortization from their assessment of earnings when, actually, a company paid that money above and beyond the value of the assets of the acquired company. So while it makes sense to exclude that amortization when you’re assessing the underlying business—the returns on the underlying business—it doesn’t make sense when you’re assessing the returns on your M&A necessarily. I feel like maybe there’s a deficiency there in how investors look at that.
Stephen: Yes, I think the problem here is with the accounting. As I say, this accounting needs to be completely redone. I do have a paper if people are interested on a proposal of how to do the M&A accounting differently.
But no, you recognize these intangible assets that are purchased. That’s a little bit putting your finger up to the wind. “What’s the value of the brand? What’s the value of this? And what’s the value of that?” It’s a bit of a fluffy number.
Then, if you’ve got to amortize it, and you only amortize with definite-lived intangibles booked, not with the indefinite-lived, then the amortization number is added back because it’s a fluffy number, too. This is like the old days when goodwill, before FASB standard 142 and 143, used to be amortized. The standard thing was to be amortized over 40 years. Analysts always added it back and said, “This is just an arbitrary number. Following a rule, you add it back. It doesn’t make any sense.”
You don’t want numbers that analysts say, “It’s too fluffy. I add it back.” Because one thing is that there is some amortization. If you have a copyright or you have a patent that’s going to expire in 25 years, well, it’s going to expire. There’s going to be a cost. You’ve got to recognize that. It’s a question of how you do the amortization.
John: Maybe we can finish by talking a little bit about the future of value investing or how it needs to adapt in this modern, knowledge-based economy, with more and more intangibles driving value. What is your view on the relevance of value investing and what, if anything, needs to change to make it more relevant?
Stephen: In some sense, I think all investing is value investing. We’re not going to escape that one. It’s a question of how you go about it. When you’re buying a stock, when you’re buying a firm, you’re buying payoffs. It’s a question of what you want to pay for those payoffs. You’ve got to get some grip on that. The question is just how you do it.
People will gamble, of course. People will gamble on all sorts of things. They’ll treat it as a casino. They’re free to do it. That’s fine. You can gamble.
But for someone who’s a little bit risk-averse and says, “Maybe if I just pull in a bit of information, I’m not going to get rid of all the risk, and maybe I’m left with a lot of risk, but I can reduce my risk by bringing in some information.” I think that’s always going to be there for those who want to put some effort into it, those who want to do some work.
Those who don’t want to do that or who feel they can’t do it, well, yes, if you want to share in the fortunes of America, just go and buy the S&P 500. You’ll share in the disappointments of America, the ups and downs. But yes, just go and do that. That’s okay. But for those who have some equipment and some understanding to actually press on it, it’s always going to be there.
You might say, “Yes, I’m going to buy the S&P 500, but let me go through and just look at a few companies. If there’s a lot of speculation around, I cannot really justify it, I may strip them out. Or I may be left with an adjusted S&P 500 with firms stripped out. I don’t have to go the full monty.”
But where’s value investing going, in answer to your question? I think the basic discipline of value investing is on the table. It’s been there for a long, long time, laid out by people like Keynes and Benjamin Graham and so on. The basic attitudes are there. I think one of the important things for an investor is just to have a lot of common sense. Bring that common sense to it, understanding the business. I think that will always be there.
In terms of technical innovations about how you might do it better, I think information is gold. The ability to grab more information about outcomes may help us improve it.
There’s a lot of difference between when I started investing; I was like Warren Buffett. I’d go to the Moody’s manuals and read what’s in the Moody’s manuals. This is way before the internet and everything else. Now we can scrape information with satellites and all sorts of things. That trend of getting more information is going to be important. But I think the basic approach to it is probably not going to change.
You’re probably going to ask about AI. I don’t know. I’m not sure it can actually do the creative thinking that a human can do when it comes to value investing, of understanding the business and combining that together with your accounting. It can do a lot in terms of bringing the information to you. But I don’t know. I’m just an observer. Let’s see what happens there.
John: Professor Penman, is there anything we have not covered that you’d still like to leave our members with before we part ways?
Stephen: I think there’s a certain person who’s adept, certain personal characteristics which are good. Keep that in mind. First of all, this is not for day traders. This requires serious long-term thinking. It requires discipline. It requires separating yourself from the herd.
Yes, you’ve got to read The Wall Street Journal and the Financial Times and pick up all the news, but do it with a distance. Be skeptical. Challenge the thinking, challenge the normal thinking. Be very thorough. Do your homework.
These are, I think, very important attributes.
In my mind, the most important attribute for a value investor is to beware of self-deception. I find this is one of my biggest problems. “Oh, I’ve written a paper. I like that paper.” You can like the paper. Let’s take it at a distance.
My kids growing up—they’re grown up now—I used to tell them, “The biggest danger is self-deception.” There’s a lot of that a teenager has. Beware of your self-deception. Test yourself. Bring the data to yourself.
Negotiate with Mr. Market. But don’t think you know everything. Say, “Well, what does he know that I don’t know? Why has he got a different opinion than I have?” Turn it back on yourself.
That is what I call being honest. Of course, it’s not just being professionally honest, which is very, very important, but it’s being honest in yourself. I think that’s a very, very important attribute to have. Don’t kid yourself.
John: On that note, Professor, thank you so much for taking the time to have this conversation. It’s been really packed with wisdom and insights. I can only warmly recommend your new book to all of our members and listeners. Truly appreciate you doing this with us. Thank you.
Stephen: Thank you very much, and it’s been good talking to you. By the way, my name is Stephen, not Professor Penman.
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