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Schmalenbach Business Review

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01.04.2016 | Original Article

Valuation: The State of the Art

verfasst von: Stephen Penman

Erschienen in: Schmalenbach Business Review | Ausgabe 1/2016

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Abstract

There is a pervasive skepticism about formal valuation models, so much so that practitioners often discard them, preferring rough-cut methods such as pricing on the basis of comparables or simple P/E ratios. This paper provides a critique of standard valuation models, identifying what is being captured (and what is not being captured) in these models. The paper then strives to develop an agenda towards more robust valuation. It stresses three points. First, any valuation must be in accord with the well-established theory of finance. However, second, the valuation must also be practical. Both are important wedges in driving a solution. Third, valuation is a matter of accounting; a valuation model is only as good as the accounting that it involves. The last point is the basis for a critique of IFRS accounting.

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Surveys of valuation models used in practice are in Demirakos et al. (2004); Hand et al. (2015); and Pinto et al. (2015).

The general no-arbitrage valuation, in Rubinstein (1976), is expressed with the discount for risk in the numerator, with that numerator then discounted at the risk-free rate: \(\textit{Value}_{\mathrm{t}}=\sum\limits_{\uptau =\mathrm{t}+1}^{\infty }\frac{{d}_{\uptau }-\textit{Cov}(d_{\uptau } ,Y_{\mathrm{t}\uptau})} {R^{\mathrm{f}}_{\mathrm{t}\uptau}}\), where Y _tτ is the time-t conditional discount factor for expected cash flows for period τ, a random variable common to all assets, and \(R^{\mathrm{f}}_{\mathrm{t}\uptau}\) is the term structure of (one plus) the spot riskless interest rates from t to τ. The identification of the Y _tτ variable is problematic (though research strives to do so), so practical valuation works with the discount for risk in the denominator, as in DDM.

Penman (2012, Chap. 2) has examples.

Some practitioners, in recognizing the problem, propose a method by which only “maintenance capital expenditure” is deducted in the free cash flow calculation. This, indeed, is “putting something else on the table”, and in fact is an alternative accounting to cash accounting, effectively booking “growth cap ex” to the balance sheet (or putting it in a bottom draw). Whether that is appropriate accounting is another question: Identifying “maintenance cap ex” is problematic and these techniques often fail to depreciate “grow cap ex”, leaving it in the bottom draw.

This is not to insist that financing activities can never create value (as in a share repurchase at a price less than value). But these effects are second order to the primary source of value creation in the operating activities of a business. In any case, any value creation by trading debt or equity is of a very different type from trading with customers and suppliers, thus requiring the separation.

Penman and Yehuda (2009) provide further detail. That paper also shows empirically that, given the components of the accrual accounting system here, free cash flows are priced in the stock market as if they are irrelevant. Further, the market prices free cash flows as reducing the value of operating activities, dollar-for-dollar, as in BS-OP; cash flows reduce NOA, dollar-for dollar under BS-OP and also reduce the (enterprise) price of operations dollar-for-dollar.

Ohlson (1995) and Feltham and Ohlson (1995) demonstrate these properties.

The equivalence of RIV and DCF is demonstrated in Lücke (1955). I have been told that Schmalenbach objected to these valuations on the grounds that forecasting for the long term is impractical. Penman (1997) shows that DCF valuation is a special case of residual income valuation, with the balance sheet recording only net debt and income calculated as free cash flow minus cash interest. (These features distinguish cash accounting from accrual accounting). Ohlson and Juettner-Nauroth (2005) derive a valuation model based on expected changes in residual income rather than (levels of) residual income. The model exhibits the same M&M properties as the residual income model and yields the same value, provided the terminal value growth rate corresponds to that for residual income. Penman (2005) compares the two models.

See Ohlson and Penman (2004) for the appropriate accounting for shareholder value for contingent-equity claims.

Note that I _τ + Accruals _τ is sometimes referred to as accruals (or total accruals) because the treatment of investment is part of the (accrual) accounting that departs from cash accounting.

The CF recognizes the issue of uncertainty, bringing the (vague) criterion of “relevance” to resolve the issue: “Even if the probability of an inflow or outflow of economic benefits is low, recognition of the asset or the liability may provide relevant information.”.

The proposed accounting helps to control the quality of the accounting. “Cookie jar reserves” and excessive restructurings and write-downs are not admitted if they have a significant probability of reversing in the future.

Verifiability would require evidence that such amortization in the past have produced low ex post error.

The FASB in the U.S. applied a similar criterion in justifying the immediate expensing of both research and development in FASB Statement No. 2: the “uncertainty of future benefits”.

This accounting does not constrain dividend policy or consumption. Under M&M conditions, firms can borrow to pay dividends, albeit with added risk to the shareholder; the firm is effectively borrowing to finance the shareholders consumption. Nor is there any constraint on investment; the cash from recognized income can be reinvested by the firm or passed out to shareholders who can then reinvest the cash.

While asset pricing theory has not been successful in specifying a discount rate, the accounting based on the resolution of risk has tantalizing promise of doing so. See Penman (2016).

Penman (2012) goes into more detail, including modifications.

Nissim and Penman (2008) lays out conditions for the application of fair value accounting. Investment funds holding traded securities apply fair value measurement such that net asset value (NAV) reports the value at which investors trade in and out of the fund. In this case the sum of the market values of the individual securities equals their joint value (the security values are separable). Financing assets and liabilities can be separated from financing assets and liabilities, so fair value accounting is possible for financing net assets if other conditions are satisfied.

Demirakos, E., N. Strong, and M. Walker. 2004. What valuation models do analysts use? Accounting Horizons 18:221–240.CrossRef

Graham, B. 1973. The intelligent investor 4, rev. ed.: 315–316. New York: Harper and Row.

Graham, B., and D. Dodd. 1934. Security analysis: principles and techniques. New York: McGraw-Hill Book Company.

Feltham, G., and J. Ohlson. 1995. Valuation and clean surplus accounting for operating and financial activities. Contemporary Accounting Research 12:689–731.CrossRef

Hand, J., J. Coyne, J. Green, and X. Zhang. 2015. The dual use of residual income and discounted cash flow valuation methods by U.S. sell-side equity analysts. Unpublished paper, University of North Carolina, Chapel Hill, NC.

IASB. 2015. Exposure draft: conceptual framework for financial reporting. London: IFRS Foundation.

Lücke, W. 1955. Investitionsrechnung auf der Grundlage von Ausgaben oder Kosten? Zeitschrift für Betriebswirtschaftliche Forschung. 7:310–324.

Miller, M., and F. Modigilani. 1961. Dividend policy, growth and the valuation of shares. Journal of Business 34:411–433.CrossRef

Modigliani, F.M., and M. Miller. 1958. The cost of capital, corporation finance and the theory of investment. American Economic Review 48:261–297.

Nissim, D., and S. Penman. 2008. Principles for the application of fair value accounting White Paper, No. 2. New York: Center for Excellence in Accounting and Security Analysis, Columbia Business School.

Ohlson, J. 1995. Earnings, Book value, and dividends in equity valuation. Contemporary Accounting Research 12:661–687.CrossRef

Ohlson, J., and B. Juettner-Nauroth. 2005. Expected EPS and EPS growth as determinants of value. Review of Accounting Studies 10:349–365.CrossRef

Ohlson, J., and S. Penman. 2004. Debt vs. equity: accounting for claims contingent of firms’ common stock performance, with particular attention to employee compensation options White Paper, No. 1. New York: Center for Excellence in Accounting and Security Analysis, Columbia Business School.

Penman, S. 1997. A synthesis of equity valuation techniques and the terminal value calculation for the dividend discount model. Review of Accounting Studies 2:303–323.CrossRef

Penman, S. 2005. Discussion of ‘on accounting-based valuation formulae’ and ‘expected EPS and EPS growth as determinants of value’. Review of Accounting Studies 10:367–378.CrossRef

Penman, S. 2012. Accounting for value. New York: Columbia University Press.

Penman, S. 2016. Valuation: accounting for risk and the expected return. Abacus 52: forthcoming.

Penman, S., and N. Yehuda. 2009. The pricing of earnings and cash flows and an affirmation of accrual accounting. Review of Accounting Studies 14:453–479.CrossRef

Pinto, J., T.J. Robinson, and J. Stowe. 2015. Equity valuation: a survey of professional practice. Charlottesville VA: CFA Institute. Unpublished paper.

Rubinstein, M. 1976. The valuation of uncertain income streams and the pricing of options. The Bell Journal of Economics 7:407–425.CrossRef

Titel: Valuation: The State of the Art
verfasst von: Stephen Penman
Publikationsdatum: 01.04.2016
Verlag: Springer International Publishing
Erschienen in: Schmalenbach Business Review / Ausgabe 1/2016
Print ISSN: 1439-2917
Elektronische ISSN: 2194-072X
DOI: https://doi.org/10.1007/s41464-016-0002-y

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