20688 - ACCOUNTING FOR VALUE
Course taught in English
Go to class group/s: 31
Class-group lessons delivered on campus
To feel comfortable in this course, you should be familiar with basic Financial Accounting topics (the background to financial statements) and basic Finance topics relevant to investment decisions and corporate financial policy (e.g., portfolio diversification, cost of capital, DCF methods). Courses could have been studied at graduate or undergraduate Level.
Value investing requires investors to estimate the intrinsic values of companies. Financial statement information is central to the value investing process. We need to understand how to infer value from such accounting numbers, e.g., earnings, book value, cash flows, return on equity, and return on assets. We need to understand the pitfalls mechanistic application of textbook models – there are traps to be avoided if we are not careful. We need to be confident in the inferences we make about the economics of businesses and the implications for valuation. While “profitability” is important in valuation, the way accounting works can distort and bias measures of profitability, obscuring “real” profitability. How can we deal with accounting measurement attributes and ways in which they might differ across companies with different business models, or companies in different industries and countries. In this course we use our knowledge of the way accounting “works” to understand the what financial statement numbers tell us, and what they do not tell us. This requires us first to appreciate some quite deep issues relating to “earnings quality,” or more generally “financial reporting quality.” However, while the quality of the accounting is important in this course and we make allowance and adjustments for aspects of accounting that obscure the economic reality, our main focus are on the issue of appreciating the value implications of accounting
Accounting numbers, when understood and used intelligenly, can help the value investor understand businesses and the value in those businesses. However, accounting can easily be misused and investors can fall into the Value Trap. We learn to understand the Value Trap and how to avoid it. The key is to develop a systematic approach to value investing using accounting numbers to understand value and to challenge the market price if it is different from estimated value. Challenging the market price helps avoid the greatest risk in investing, the risk of paying too much. The main topics we consider are as follows:
- Principles of value investing.
- The Value Trap and How to Avoid It.
- Accounting for the Market Price.
- Accounting for Leverage and Financing Risk.
- Accounting for the Profitability of the Business.
- Accounting for Growth.
- Accounting for Growth and Risk.
- Accounting for Value in the Balance Sheet.
- Accounting for Value in the Income Statement.
- Accounting for Value in Special Situations.
- Understand the challenges and information needs of traditional and quantitative value investors.
- Explain the role of fundamental finance and accounting principles in accounting-based valuation of the firm and in challenging market prices.
- Explain how accounting-based valuation models can be obtained from the dividend discount model.
- Understand the advantages of accounting-based valuation relative to discounted cash flow models.
- Discuss the relevance of measures of accounting value and profitability in valuation.
- Explain the effects of financial leverage and operating leverage in valuation.
- Explain the connections between growth and risk in accounting-based valuation.
- Understand the importance of separating financing and operating activities in valuation of the firm.
- Discuss concepts of accounting quality in the context of the balance sheet and income statement.
- Explain how speculation in future growth can be an important element in market prices of firms’ securities.
- Estimate the intrinsic value of firms based on reported and projected financial statement information.
- Demonstrate how valuation multiples, profitability and leverage measures articulate.
- Critically analyze the growth expectations implied by market prices with reference to knowledge of the business and the drivers of value, growth and risk.
- Reformulate financial statements to separate financing and operating activities and to eliminate GAAP procedures that may obscure business fundamentals.
- Work with published financial statements to assess the quality of financial statement information for valuation to inform investment decisions.
- Apply financial statement analysis methods and diagnostics to assess potential sources of growth and risk, including accounting risk.
- Develop comprehensive case study reports for value investors based on financial statements and broader financial narratives from regulatory filings and annual reports.
- Apply the theoretical framework developed in the course to evaluate special situations including mergers and acquisitions and corporate restructuring.
- Use the theoretical framework developed in the course to evaluate accounting-based stock market anomalies that suggest the predictability of stock market returns.
- Face-to-face lectures
- Guest speaker's talks (in class or in distance)
- Exercises (exercises, database, software etc.)
- Case studies /Incidents (traditional, online)
- Group assignments
The learning experience of this course is based on:
- Face to face: lectures are interactive, as Accounting is a very practical course: real-life cases are presented during teaching, with the goal of linking the explanation to the “real world of business and accounts”. After each set of lectures regarding a certain topic we discuss real life, contemporary cases in detail.
- Incidents: papers, press news and practical small cases are provided and discussed in class.
- Project: an assignment with the analysis of data, review of relevant literature and development of a key “accounting question” is given to students and discussed in class through a presentation.
With a view to assessing the achievement of the learning outcomes outlined above, attending students are assessed based on:
- To accommodate the switch to remote teaching and learning as a result of the Covid-19 Crisis, the Class participation grade, previously with a weight of 15%, will be replaced by 2 homework assignments containing exercises that will also serve as good preparation for the final exam. You will be asked to submit two individual pieces of homework, each with a weight of 7.5%.
The timing will be after the Easter break period. I plan to assign one homework in the week beginning 20 April, and one in the week beginning 27 April.
This will allow you time in the period before to make good progress in your group project assignments. Remember that the date set in the syllabus for the project presentations is 6 May. Reports should be submitted by 5 May at latest.
- A case project report and presentation prepared by small groups of students (40% of the final grade). The project is designed to test the ability of students to apply theoretical knowledge of accounting-based valuation methodologies to test the current market prices of one or more real companies using firms’ real world published financial statement information and other financial disclosures; to demonstrate understanding of the ability and limitations of financial statements to reveal information about business economics; and to assess the growth prospects and risks associated with investing in specific companies and their implications for the value investor using financial statement analysis methods.
- Written exam (45% of the final grade) aimed at testing students understanding of the theoretical relationships between intrinsic value, measures of accounting value and profitability, leverage, growth and risk; and to apply this knowledge in calculations based on simplified examples abstracting from real world detail.
- An individual case project report and presentation (50% of the final grade). The project is designed to test the ability of students to apply theoretical knowledge of accounting-based valuation methodologies to test the current market prices of one or more real companies using firms’ real world published financial statement information and other financial disclosures; to demonstrate understanding of the ability and limitations of financial statements to reveal information about business economics; and to assess the growth prospects and risks associated with investing in specific companies and their implications for the value investor using financial statement analysis methods.
- Written exam (50% of the final grade) aimed at testing students understanding of the theoretical relationships between intrinsic value, measures of accounting value and profitability, leverage, growth and risk; and to apply this knowledge in calculations based on simplified examples abstracting from real world detail.
The course material is exclusively represented by:
- S. PENMAN, Accounting for Value, Columbia Business School Press.
- Slides - provided through Bboard.
- Readings - provided through Bboard and in S. PENMAN, Financial Statement Analysis and Security Valuation, Irwin/McGraw-Hill, 2013, 5th ed.
The course materials (e.g., hands outs and teaching notes) are regularly downloadable from Bboard platform. Teachers make the materials available throughout the course.