Handling Valuation Models

10 Pages Posted: 9 Nov 2006

See all articles by Stephen H. Penman

Stephen H. Penman

Columbia Business School - Department of Accounting

Abstract

Valuation models are useful tools, but they need to be handled with care. When taking the form of mathematical formulas, they can easily be made to convey a false sense of precision. In particular, selective choice of long-term growth rates and discount rates can be used to justify almost any desired valuation.The author shows how relatively simple valuation models can be applied by active investors in a way that honors the fundamentalist dictum of building valuations on the foundation of "what we know" and avoiding speculation about long-term growth rates. The article also emphasizes the role of accounting in discovering what we know, and shows how to use accounting results in a way that not only minimizes speculation about growth rates and discount rates, but actually challenges the speculation about those rates that is implicit in current stock prices. Accounting-based valuation models are "reverse-engineered" to discover the forecasts of future operating performance that are effectively built into current prices, so the plausibility of such forecasts can be evaluated with fundamental analysis. In this sense, valuation models are used not so much to discover the "right" price as to identify, and then subject to critical examination, the market's current expectations about future performance.

The author shows how relatively simple valuation models can be applied by active investors in a way that honors the fundamentalist dictum of building valuations on the foundation of what we know and avoiding speculation about long-term growth rates. The article also emphasizes the role of accounting in discovering what we know, and shows how to use accounting results in a way that not only minimizes speculation about growth rates and discount rates, but actually challenges the speculation about those rates that is implicit in current stock prices. Accounting-based valuation models are reverse-engineered to discover the forecasts of future operating performance that are effectively built into current prices, so the plausibility of such forecasts can be evaluated with fundamental analysis. In this sense, valuation models are used not so much to discover the right price as to identify, and then subject to critical examination, the market's current expectations about future performance.

Suggested Citation

Penman, Stephen H., Handling Valuation Models. Journal of Applied Corporate Finance, Vol. 18, No. 2, pp. 48-55, Spring 2006. Available at SSRN: https://ssrn.com/abstract=943542 or http://dx.doi.org/10.1111/j.1745-6622.2006.00087.x

Stephen H. Penman (Contact Author)

Columbia Business School - Department of Accounting ( email )

3022 Broadway
New York, NY 10027
United States
212-854-9151 (Phone)
212-316-9219 (Fax)

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