Benjamin Graham's Accountant

This is a special guest post by Stephen Penman. Stephen Penman is  George O. May Professor of Accounting at the Columbia Business School. He is the author of “Financial Statement Analysis and Security Valuation“,  for which he received a Wildman Medal Award. He also recently authored a book titled Accounting for Value. The book’s novel approach shows that valuation and accounting are much the same: valuation is actually a matter of accounting for value. Stephen is also an editor of the Review of Accounting Studies.

Value investing delves into “the fundamentals” of a firm. That means knowing a business well, understanding its strategy, its markets, and its management. But often we take the measure of a business through its accounting numbers—its sales, margins, cash flows, its balance sheet position. Indeed we focus on accounting numbers to such an extent that that accounting numbers themselves are often referred to as “the fundamentals.”  That is appropriate, for valuation involves quantification—we look for a dollar number—and accounting numbers translate business activities into dollars. Indeed, one can think of valuation as a matter of accounting for value: When one values a firm one is essentially doing an accounting for its value. That is the theme in my recent book, Accounting for Value.

The idea raises two issues. First, how do I actually account for value? How do I get from accounting numbers to a valuation? Second, if I am going to use accounting in valuation, what do I want the accounting to look like? Is it historical cost accounting? Fair value accounting? Is it GAAP accounting?

To answer these questions, let’s stick with the principles that the fundamental investor lives by, from Benjamin Graham on. Price is what you pay, value is what you get. Price is speculative so, to challenge the price, understand what you know and separate what you know from speculation. And importantly, anchor your valuation on what you know rather than speculation. Benjamin Graham saw value as follows:

Value = Minimum true value + Speculative value