Research on Valuation and Financial Statement Analysis A Product Focus

1. Research on Valuation and Financial Statement AnalysisA Product Focus Stephen Penman Columbia University CKGSB-PKU-Tsinghua Accounting Summer Camp July 9 -11, 2007

2. 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

3. Session 1 What is accounting research all about?

4. 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

5. 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

6. 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)?

7. 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

8. 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

9. A Good Valuation Product? The Capital Asset �Pricing Model� Good Concepts? - Don�t 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?

10. 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?

11. A Good Valuation Product? The Method of Comparables Concept No Arbitrage Good features Easy, uncomplicated Side effects Pyramid Schemes

12. A Good Valuation Product?

13. 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

14. 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

15. 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

16. 1930-1970: Normative �accounting theory� A priori analysis using author�s 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

17. 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

18. 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�?

19. 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

20. 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

21. 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

22. Modern Accounting Theory(Based on the Foundations of Economics) Financial accounting theory: Disclosure theory Agency theory Valuation theory Contribution: - Good for ordering one�s 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: M&M Provides a representation of how accounting works for valuation Incorporates features of the accounting product

23. Valuation Research: the Starting Point The Dividend Discount Model (DDM): But it doesn�t 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

24. 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

25. A Product of Modern Finance: DCF Does it work?

26. Does DCF Work for Home Depot? Home Depot, Fiscal 1997-2001 (in millions of dollars) V = ? Professor: I have a terminal value problem!

27. An Earnings Model (Gordon Model) It does not work for the savings account: Required return = 5%; Earnings rate = 5%; Reinvest so growth is 5%

28. The Residual Earnings Model

29. Developing the Earnings Model (Ohlson and Juettner-Nauroth)

30. 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)

31. 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)

32. 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

33. 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.

34. 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.

35. A Good Valuation Product?

36. 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

37. 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

38. 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)

39. 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)

40. 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.

41. 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.

42. 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. References and Further Reading (Continued)

43. 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. References and Further Reading (Continued)