Performance measurement: an investor's perspective

Abstract

This article discusses the role of GAAP accounting from an investor's perspective. For all its flaws, a historical-based system of accounting is vital to the investment community, and I believe the moves toward fair value accounting should proceed with great caution. Framing the discussion in terms of valuation theory, I argue that investors are typically more interested in assessing the present value of residual income than the value of assets-in-place. I also provide examples of how historical accounting numbers can be (and are being) used by professional investors. A simple residual-income framework succinctly captures the essence of value investing. In fact, what academics have learned about fundamental investing in recent years dovetails nicely with the strategies used by legendary investors such as Ben Graham, Warren Buffett, and Joel Greenblatt.

Keywords:

• market efficiency
• fundamental analysis
• equity valuation
• fair value accounting
• performance measurement

Acknowledgements

Lee wishes to thank Mary Barth, Bill Beaver, Daniel Beneish, Beth Blankespoor, Will Cong, Craig Nichols, Jim Ohlson, Stephen Penman, Scott Richardson, Eric So, and especially Gilad Livne (the reviewer) for their helpful comments and suggestions.

Notes

1. Statement of Financial Accounting Concept No. 8 states explicitly that ‘(g)eneral purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders, and other creditors to estimate the value of the reporting entity’ (FASB 1978; Objective No. 8).

2. Or, from a balance-sheet perspective, we cannot book something as an asset if the firm does not have clear control over it.

3. More precisely, I believe the standard-setting language of today uses ‘past exchanges, transactions, and other changes in circumstances’. What other changes in circumstances we should attempt to measure, beyond economic exchanges and transactions, is somewhat nebulous.

4. For example, what prevents us from recognizing an asset called ‘Value of Corporate Brand’, computed as the difference between a firm's book equity and its stock price? Such an asset appears to meet our market test for objective pricing. One could argue that it is really no different from acquired goodwill, in terms of its economic worth to the company and in terms of the level of control a firm has over it going forward. And if we book such an asset, should not we also book changes in the value of this asset as part of corporate earnings? In that case, are we not back to reporting stock returns as our performance measure?

5. Many studies document the fact that stock returns move for reasons other than fundamental news. For example, see Roll (1984)'s classic analysis of orange juice futures. See Lee (2001) for an early discussion on the impact of the market efficiency hypothesis on capital market research.

6. See, for example, Cutler et al. (1989), Shiller (1981, 1984), Campbell and Shiller (1988), Lee et al. (1991), and Summers (1986). In Cutler et al. (1989), annual aggregate market returns are regressed against a large array of fundamental metrics in a vector auto-regressive system of equations. Even though the authors included measures of fundamental news from past, current, and future periods, they were able to explain less than half of the observed variance in market returns. These results are based on market aggregates; efforts at explaining firm-level returns are met with even less success.

7. See Hirshleifer (2001) for an earlier summary of how psychology can affect prices. Many more recent studies have appeared since that article. Some representative studies include Baker and Wurgler (2007), Coval and Stafford (2007), Richardson et al. (2012), Kumar and Lee (2006), and Arif and Lee (2014). In most of these studies, measures of investor sentiment are first ‘orthogonalized’ (pre-whitened) relative to a host of fundamental news variables. Nevertheless, these studies show investor sentiment explains, and in some cases even predicts, stock returns.

8. There is now a large literature on the limits of arbitrage. Some representative studies include Shleifer and Vishny (1997), Brunnermeier and Nagel (2004), and Hirshleifer et al. (2009).

9. See Lee (1999) for an expanded discussion of the relation between historical accounting numbers and firm value. This applies to various derivatives of the discounted cash flow model, as well as permutations of the RIM, however, we specify the starting capital base.

10. For example, FASB's Statement of Financial Concepts No. 1 states that a primary objective of financial accounting is to provide information useful in ‘assessing the amounts, timing, and uncertainty of prospective cash receipts’ to the company (FASB 1978, p. ix).

11. I am indebted to Professor Aswath Damodaran for bringing my attention to this screen. See Damodaran (2012) for an excellent historical perspective on value investing. See Cottle et al. (1988) for a current version of the Graham and Dodd (1934) classic.

12. Bernard (1995), Lundholm (1995), and Lee (1999) offer less technical discussions on the implications of Ohlson's work. Many excellent books, including Healy and Palepu (2012), Penman (2010, 2012), and Wahlen et al. (2010), discuss implementation details. Ohlson often underscores the fact that a RIM lacks content without additional assumptions (e.g., the ‘Linear Information Dynamics’ assumptions in Ohlson 1995).

13. In this formula, the residual income for period t is defined in terms of period t earnings, minus a normal rate-of-return on the beginning capital base. Notionally: RI_t = NI_t – (r * B_r−1).

14. Clean surplus accounting requires all gains and losses affecting the starting capital to flow through earnings. In short, any changes in the capital base must come either from earnings during the period or from net new capital flows. For example, if we define the starting capital base as the beginning-of-year book value, then the ending book value must equal the starting book value plus earnings minus net dividends: (B_t = B_t−1 + NI_t − D_t).

15. The two consistency requirements are: first, the three elements of RI need to be consistently defined: having specified the capital base (Capital_t), Earnings_t must be the income to that capital base in year t, and r must be the cost-of-capital associated with this source of capital. Second, the evolution of the capital base in this model must follow the CSR.

16. For example, Ohlson and Juettner-Nauroth (2005) and Easton (2004) use capitalized one-year-ahead earnings (EARN_t + 1) as the starting capital base in developing the Abnormal Earnings Growth Model. Bhojraj and Lee (2002) use the RIM formula to estimate a matching PVRI for each firm's EV/S ratio.

17. Although the arithmetic carries through, clearly not all measures of capital are equally sensible from an economic perspective. A full analysis of which ‘capital-in-place’ measures might be more sensible is beyond the scope of the current discussion. However, it might be worth noting in passing that granting greater latitude to management in reappraising balance-sheet items could have the unhappy side-effect of producing less comparable accounting rates-of-return, both for cross-sectional and for time-series analyses.

18. Technically, it is not expected ROE per se, which appears in the formula, so much as the expected Net Income divided by the expected book value. Recall from the CSR, B_t + 1 = B_t + NI_t − DIV_t = B_t * (1 + (1 − k) ROE_t + 1); therefore, the growth in book value is simply: B_t + 1/B_t = 1 + (1 − k) ROE_t + 1.

19. From the Chairman's letter, Berkshire Hathaway, Inc., Annual Report, 1989.

20. At least one other accounting academic came to the same conclusion about Buffett's investment strategy. In his 2010 book, Buffett beyond Value, Professor Prem Jain (2010) studied over 30 years of Buffett pronouncements and also came to the same conclusion. Buffett favored quality growth (or in RIM parlance, high PVRI firms) over cheapness.

21. See, for example, Gray and Carlisle (2013, Chapter 2) for a detailed replication of the formula using US data from 1964 to 2011.

22. For a much more detailed review of this debate, see Zacks (2011; Chapter 10).

23. Both Dichev (1998) and Campbell et al. (2008) find strong evidence that distress risk is actually negatively associated with subsequent returns. Dichev used Altman's Z-score and Ohlson's O-score and showed that going long in the 70% of firms with low bankruptcy risk, and shorting the remaining 30%, yields positive returns in 12 out of 15 years (1981–1995). Campbell et al. (2008) sort stocks by value-weighted portfolios by failure probability, and find that average excess returns are strongly, and almost monotonically, negatively related with the probability of failure. The safest 5% of stocks have an average excess yearly return of 3.4%, while the riskiest 1% of stocks have an average return of −17.0%.

24. Consistent with this argument, Chava and Purnanadam (2010) showed that although distress risk is negatively correlated with future realized returns, it is positively correlated with a firm's market-implied cost of capital. In other words, the market does use a higher implied discount rate when discounting the future earnings of high distress firms; however, because these firms are still over-priced on average, they still earn lower future realized returns.