Today’s investors are witnesses to a fierce battle between two methods of stock market valuation – the battle between accounting and finance. Why is this battle so important and why are the stakes so high? To answer this question, let us examine the case of The Feathered Feast by Jack Treynor, former editor of The Financial Analyst Journal and one of the truly great minds in finance. The entire case is reprinted in the Appendix and the reader is encouraged to spend the time to read it in its entirety. We will use the ideas presented in this case to inspire a larger discussion of why the fallacies of accounting are responsible for the inaccurate categorization of “growth” and “value” investments.
As stated in its opening paragraph, the case of The Feathered Feast concerns the disclosure of financial information and the dual purposes to which it is put to use. Treynor notes that the accountant and the investor are at two ends of the financial valuation spectrum. On the one hand, the accountant’s objective is to fairly represent the state of the business at a point in time (the balance sheet) and to record the receipts and expenses to show profits or losses (the income statement). On the other hand, the investor attempts to take the accountant’s data to create a fair market value by discounting future expected earnings with an assumed appropriate discount rate (the reciprocal of the P/E ratio). At the heart of the investor’s assumption is the expected stream of earnings or cash flows to be derived from the net assets owned by the entity. So far so good. But the problem is that the accountant’s definition of the estimated useful life of an asset can be very different from the investor’s definition.
Let’s take a closer look at why the fields of accounting and finance have different ways of determining the value and longevity of an asset, and why the accountant’s approach can lead to trouble.
First of all, it’s safe to say that accountants follow at least one particular principle that distorts financial realities – the allocation of the cost of an asset over the expected useful life of the asset. This is the accountant’s notion of depreciation. To phrase it differently, depreciation, in the eyes of the accountant, is represented by an annual charge against an asset’s purchase price in order to reflect the decline in the value of that asset. Here is an example that will bring the inherent faultiness of this concept to light. Airplanes were once commonly thought to have “useful” lives of 10 to 15 years per accounting conventions. However, after 40 years, many airplanes are still flying. Pipelines are another good example. There is an annual depreciation charge to the expected life of a pipeline, but does one really believe this pipeline is worth less on an annual basis when astute buyers are actually paying more and more for each additional mile of pipeline every year? By the same token, what is implied when a manufacturing firm builds a new plant with an estimated life of 30 years only to learn a year later that the widgets it was to produce have become technologically obsolete? In this case, should not the depreciation rate be 100%?
Jack Treynor provides another perfect example of the accountant’s miscalculation of the fair value of assets. In The Feathered Feast, the value of the restaurant outlets implied by the accounting analysis was inconsistent with the economic reality. This is because the changing value of the assets (the outlets) did not match the assets’ ability to generate earnings over time.
Finance, on the other hand, offers a more realistic concept of an asset’s value and longevity. This concept is based on the present value principle. This principle says that there is a stream of benefits (cash flows) derived from the purchase of an asset, and the asset’s present value is determined by discounting this value by the firm’s cost of capital.
Why are these two approaches so different, and what does this difference mean? Let’s look at an example in which a company purchases a tangible asset, such as the aforementioned airplane. Under the accountant’s approach, the airplane has a fixed life of a decade or so. However, under the investor’s approach, the fixed life of the airplane can be nearly infinite. Needless to say, these two approaches can result in wildly different book values for the exact same company asset. This is the reason book value is often a worthless concept for an investor. Book value reflects the accountant’s flawed concept of depreciation, and generally bears no relation to the true time value of an asset as reflected in the public securities markets. There is no cost of capital within the accountant’s methodology, even though cost of capital is incredibly relevant to finance. Why does finance offer the correct approach? Because the annual depreciation of an asset should not be immune to changes in interest rates, nor should depreciation be the same in an 8% interest rate environment as in a 4% interest rate environment. Simply put, the accounting approach ignores these critical details, while the finance approach incorporates them via the use of cost of capital.
Therefore, book value and earnings are accounting constructions that are of little use to investors and finance professionals. Similarly, the popular valuation ratios that are derived from these accounting concepts (i.e. P/E and P/BV) also serve a questionable purpose because, within these ratios, the accountant’s approach and the investor’s approach are mixed together providing little insight to the investor.
A security’s price is, by definition, a concept based in finance, while the concepts of book value and earnings are the products of accounting. To illustrate the dangers of mixing finance (a security’s price) with accounting (book value, earnings), consider what happens when a company repurchases its stock. On the company’s books, there is a debit to Treasury stock and a credit to cash. Treasury stock is a reduction to stockholders equity, so this transaction has the effect of lowering the firm’s book value, and therefore increasing its P/BV ratio. It also has the effect of raising its “Return on Equity,” because the numerator (earnings) has remained unchanged but shareholder equity has been reduced. If done often enough and in large amounts, one could see how a company’s placement into a certain investment category could change dramatically for this reason alone. If we use the accountant’s approach, a company could easily migrate from the “value” category to the “growth” category through a mere reshuffling of its assets and shareholders equity components.
From the above analysis, we can see that the use of P/E and P/BV ratios is a misleading way to categorize companies. In the same way, it is also ineffective and inaccurate to put investment managers in a “growth” or “value” category by using the P/E and P/BV criteria. Why? Because neither of these ratios provides a true window into whether the investment manager is actually following a “growth” strategy or a “value” strategy. However, a quick look at popular market indices shows us that P/E and P/BV are still being used to mis-categorize investment managers. For example, indices such as Barra Growth or Barra Value are sorted based on a P/BV ratio scale. The companies with the 600 highest P/BV ratios are labeled “growth” and the companies with the 600 lowest P/BV ratios are labeled “value”. From the evidence presented in this paper, it is clear why this kind of categorization is misleading, and it is easy to understand how the use of accounting methods can be a disservice to investors.
The main point here is that accounting is a contrived language that provides false criteria for investment decisions and categorizations. The language used by accountants communicates little to an investor about the true profitability of the business, let alone a proper valuation for it. Therefore, it is both dangerous and inaccurate to categorize companies or investment managers based on the accountant’s methods. However, we can look to finance to provide superior insight into the true characteristics of an investment opportunity. The battle between accounting and finance has not yet been won, but it is clear which side should prevail.