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PhD Seminar B9010, Columbia Business School
Valuation and Financial Statement Analysis
Stephen Penman, Fall 2018
This seminar covers on-going theoretical and empirical research on financial accounting, valuation, and financial statement analysis.
The seminar has three themes:
First , we have a product focus. Unlike a natural science like physics or chemistry, accounting research is not an endeavor to discover how the world works. Rather, it is a design problem, a matter of constructing products to serve customers. In our case, the customer is the investor.
We focus on three products in this seminar:
(1) valuation products,
(2) financial statement analysis products, and
(3) accounting itself as a product for financial reporting.
Think of the residual income model as a valuation product, the Altman Z-score for bankruptcy prediction as a financial statement analysis product, and fair value accounting as a financial reporting product. Think of the complete set of accounting standards of the FASB and the IASB as a product. Are these good products or are they deficient? Can we design alternative products based on our research?
Clearly the three issues are connected: How one carries out a valuation or financial statement analysis depends on the accounting involved, so issue (3) impinges issues (1) and (2). And issues (1) and (2) provide insights for issue (3): If the accounting is “bad,” it frustrates valuation and financial statement analysis, providing feedback for how accounting might be improved.
Second , the structural features of accounting—the framing architecture of the financial statements—are important for both research design and product design. These structural features are given by the set of accounting relations that tie the financial statements together. So, for example, the following are structural accounting relations:
Shareholders’ Equityt = Assetst – Liabilitiest
Shareholders’ Equityt = Shareholders’ Equityt-1 + Comprehensive Incomet – Net Dividendt
Free Cash Flowt = Operating Incomet – Change in Net Operating Assetst
Earnings is not just an isolated number, but one that comes from a set of structural equations that determine what the number is conveying. These are features that must be recognized (and exploited) in research design and in the product design that flows from the research. What are their properties and how are those properties exploited in developing valuation and financial statement analysis products?
Third , measurement must be put on the components of the structure. Should assets be measured at fair value? Should R&D be measured as an asset on the balance sheet? Accounting principles govern measurement, so the question is the appropriate accounting principles for valuation and financial statement analysis. Earnings is a number delivered via a set of structural accounting equations, but also under accounting principles that dictate its measurement Book rate-of-return is not “real” profitability but an accounting measure affected by accounting principles. How, then, does one interpret a book rate of return for valuation and financial statement analysis?
In sum, the aim of research is to answer the question: What is “good” accounting? To answer this
question, we focus on two product areas: valuation and financial statement analysis.
Assessment
Enrolled students will be graded on oral presentations and class participation (25%), a take-home
exam (25%), and a written research proposal (50%). Both the take-home exam and the research
proposal are due January 23, 2018. The take-home exam must be done individually, without consultation with other students. The research proposal can be discussed with other students and
with Penman. Unenrolled participants are welcome to join in oral presentations if time permits.
Readings
Published papers can be downloaded from Columbia Libraries E-Journals. Unpublished papers are available from ssrn (as indicated) or will be posted to Canvas. All the papers listed are necessary to grasp the material, though we will not get to all of them in class sessions. Follow the trail through the references to further material.
Preliminary Reading (and further reading during and after the seminar):
The first two papers highlight themes in the seminar:
Penman, S. Eye on the Prize: Directions for Accounting Research, China Accounting Review Vol. 6, No. 4 (December 2008), 465-476.
Klamer, A. and D. McCloskey. Accounting as the Master Metaphor of Economics, European
Accounting Review 1 (May 1992), 145-160.
The following two books are for the classroom and practitioners. They indicate the extent to which research has entered the product arena to date:
Penman, S. Financial Statement Analysis and Valuation , 5th^ ed. New York: McGraw-Hill/Irwin,
Beaver, W., M. Correia, and M. McNichols. Financial Statement Analysis and the Prediction of Financial Distress. Foundations and Trends in Accounting , Vol. 5, No. 2 (2011).
Hodder, L., P. Hopkins, and K. Schipper. Fair Value Measurement in Financial Reporting. Foundations and Trends in Accounting , Vol. 8, No. 3-4 (2014).
Monahan, S. Financial Statement Analysis and Earnings Forecasting. Foundations and Trends in Accounting , Vol. 12, No. 2 (2018).
In the reading list below, papers indicated by an asterisk (*) are ones we will cover in class. The other papers are also required for your wider reading.
Session 1. Introduction
Outline of the Seminar
Background: Capital Markets Research
Ball, R., and P. Brown. An Empirical Evaluation of Accounting Income Numbers. Journal of
Accounting Research (1968), 159-178.
Beaver, W. 1968.The Information Content of Annual Earnings Announcements. Journal of
Accounting Research 6, 67-92.
Beaver, W. Financial Ratios as Predictors of Failure. Journal of Accounting Research 4 (1966),
71-111.
Identification
Gow, I., D. Larcker, and P. Reiss. 2016. Casual Inference in Accounting Research. Journal of Accounting Research 54 (2), 477-523.
Marinovic, I., ed. 2016. Causal Inferences in Capital Markets Research. Foundations and Trends in Accounting Vol. 10, No. 2-4.
Harvey, C. 2017. Presidential Address: The Scientific Outlook in Financial Economics. Journal of Finance 72, 1399-1440.
Lòpez de Prado, M. 2015. The Future of Finance. Journal of Portfolio Management (Summer).
Ohlson, J. 2015. Accounting Research and Common Sense. Abacus 51, 525-535.
Ohlson, J. 2017. Researchers’ Data Analysis Choices: An Excess of False Positives? Unpublished paper, Hong Kong Polytechnic University (on Canvas).
Ohlson, J., and S. Kim. 2016. Linear Valuation without OLS: the Theil-Sen Estimations Approach. Review of Accounting Studies 21. https://ssrn.com/abstract=2276927.
Session 2. Accounting and Valuation: Theory I
Finance Theory:
*Miller, M., and F. Modigliani. 1961. Dividend Policy, Growth and the Valuation of Shares. Journal of Business 34, 411-433.
*Rubinstein, M. 1976. The Valuation of Uncertain Income Streams and the Pricing of Options. The Bell Journal of Economics 7, 407-425.
*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.
Session 5. Accounting and Valuation: Empirical Analysis
Penman, S., and T. Sougiannis. The Dividend Displacement Property and the Substitution of
Anticipated Earnings for Dividends in Equity Valuation, The Accounting Review (January 1997),
1-21.
*Penman, S., and T. Sougiannis. A Comparison of Dividends, Cash Flow, and Earnings
Approaches to Equity Valuation, Contemporary Accounting Research (Fall 1998), 343-383.
Johannesson, E., and J. Ohlson. 2016. Explaining Returns through Valuation. Unpublished
paper, Columbia University and Hong Kong Polytechnic University.
Penman, S. 2016. Valuation: The State of the Art, Schmalenbach Business Review 17 (April), 3-
Session 6. Financial Statement Analysis
Nissim, D. and S. Penman, Ratio Analysis and Equity Valuation: From Research to Practice, Review of Accounting Studies 6 (2001), 109-154.
*Nissim, D., and S. Penman. Financial Statement Analysis of Leverage and How it Informs
about Profitability and Price-to-Book Ratios. Review of Accounting Studies 8 (2003), 531-560.
*Penman, S., and X. Zhang. 2002. Accounting Conservatism, Quality of Earnings, and Stock
Returns. The Accounting Review 77(2): 237-264.
Piotroski, J. 2000. Value Investing: The Use of Historical Financial Statement Information to
Separate Winners from Losers. Journal of Accounting Research 38 (Supplement), 1-41.
Penman, S., and X. Zhang. 2006. Modeling Sustainable earnings and P/E ratios with financial statement analysis. At http://ssrn.com/abstract=318967.
Correia, M., S. Richardson, and İ Tuna. 2012. Value investing in credit markets, Review of Accounting Studies 17, 572-609.
Session 7. Asset Pricing and Accounting
Asset Pricing
Ross, S. 2017. Factors—Theory, Statistics, and Practice. Journal of Portfolio Management , Special Issue , 1-6.
Videos on factor investing:
https://www.researchaffiliates.com/en_us/insights/videos.insights.html#/page=0/search=
*Fama, E., and K. French. 1992. The cross-section of expected stock returns. Journal of Finance 47, 427-465.
Fama, E., and K. French. 1993. Common risk factors in the returns of stocks and bonds. Journal of Financial Economics 33, 3-56.
Accounting and Asset Pricing
*Penman, S., S. Richardson, and İ. Tuna. 2007. The Book-to-Price Effect in Stock Returns:
Accounting for Leverage. Journal of Accounting Research 45, 427-467.
Penman, S., and F. Reggiani. 2013. Returns to Buying Earnings and Book Value: Accounting for Growth and Risk. Review of Accounting Studies 18, 1021-1049.
*Penman, S., F. Reggiani, S. Richardson, and İ Tuna. 2018. A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-to-Price. European Financial Management , forthcoming. At http://ssrn.com/abstract=2962620.
Ohlson, J. Risk, Growth, and Permanent Earnings. Unpublished paper, Arizona State University,
- (On Canvas).
Hou, K., C. Xue, H. Mo, and L. Zhang. 2017. The Economics of Value Investing. Unpublished paper, The Ohio State University. (On Canvas)
Session 8. Return Anomalies and Accounting
*Sloan, R. 1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315.
Richardson, S., İ Tuna, and P. Wysocki. 2010. Accounting anomalies and fundamental analysis: a review of recent research advances. Journal of Accounting and Economics 50, 410-454.
Penman, S. 2016. Valuation: Accounting for Risk and the Expected Return. Abacus 52 (1), 106-
*Penman, S. and J. Zhu.2018. The Implied Cost of Capital, Growth and Risk. Mimeo.
Session 11. Accounting and the Cost of Capital II
*Penman, S. and J. Zhu. 2018. A Fundamental Factor Model. Working paper.
Penman, S., and X. Zhang. 2017. A Theoretical Analysis Connecting Conservative Accounting to the Cost of Capital. Unpublished paper, Columbia University and University of California, Berkeley. At http://ssrn.com/abstract=
Session 12. Product Development: Accounting Policy and Tools for Financial Statement Analysis
Penman, S. Accounting for Value , Chapters 8 and 9.
Ohlson, J. and S. Penman, Debt vs. Equity: Accounting for Claims Contingent of Firms’
Common Stock Performance, with Particular Attention to Employee Compensation Options. White Paper No. 1, Center for Excellence in Accounting and Security Analysis, Columbia
Business School (2004). http://www8.gsb.columbia.edu/ceasa/
*Nissim, D., and S. Penman, Principles for the Application of Fair Value Accounting , White Paper No. 2, Center for Excellence in Accounting and Security Analysis, Columbia Business School (2007). http://www8.gsb.columbia.edu/ceasa/
American Accounting Association Financial Accounting Standards Committee, J. Ohlson and S. Penman principal coauthors, A Framework for Financial Accounting Standards: Issues and a Suggested Framework, Accounting Horizons 24 (2010), 471-485.
*Barker, R. and S. Penman. Moving the Conceptual Framework Forward. Unpublished Paper, Oxford University and Columbia Business School, 2016. www.gsb.columbia.edu/ceasa
Penman, S. The Design of Financial Statements , Occasional Paper, Center for Excellence in Accounting and Security Analysis, Columbia Business School. At http://www8.gsb.columbia.edu/ceasa/.
*Penman, S. Accounting for Intangible Assets: There is also an Income Statement. Abacus 45
(September 2009), 359-371. Also an Occasional Paper, Center for Excellence in Accounting and
Security Analysis, Columbia Business School (2009) at http://www8.gsb.columbia.edu/ceasa/.
Oh, H. 2016. An Alternative Approach for Mergers and Acquisitions Accounting and Its Use for Predicting Acquirers’ Performance. Unpublished paper, University of Washington, Bothell. http://www8.gsb.columbia.edu/ceasa/
Penman, S. 2017. Prudent Capital and Prudent Accounting for Banks. Unpublished paper, Columbia University.
Post Script: Papers Applying Research to Practical Fundamental Investing
(Unpublished papers are on Canvas)
Macquarie Research, Quantamentals: Rethinking Value. November 2015.
Macquarie Research, Quantamentals: Know Your Value. February 2016.
Bartram, S. and M. Grinblatt. 2017. Fundamental Analysis Works.
Richardson, S., R. Sloan and H. You. What Makes Stock Prices Move? Fundamentals vs. Investor Recognition.
Ak, B. and X. Zhang. 2017. Predicting Large Negative Stock Returns: The Trouble Score.
Ak, B. and X. Zhang. 2017. Relative Informativeness of Top Executives’ Trades in Financially Distressed Firms Compared to Financially Healthy Firms.
Yao, T., T. Yu, T. Zhang, and S Chen. 2010. Asset growth and stock returns: Evidence from Asian financial markets.
Piotroski, J., and E. So. 2011. Identifying Expectation Errors in Value/Glamour Strategies: A Fundamental Analysis Approach.
Yu, J. and Y. Yuan. 2010. Investor Sentiment and Anomalies.
