Value Investing

The Importance of Understanding Accounting in Value Investing

The principal investment strategy of the Gotham Large Value Fund (managed by Gotham Asset Management) nicely conveys what value investing attempts to achieve:

The Adviser seeks to capitalize on pricing inefficiencies in the market by employing a systematic, bottom-up, valuation approach based on the Adviser’s proprietary analytical framework to identify companies that appear to be undervalued on both an absolute and relative basis. This approach consists of:

• Researching and analyzing each company in the Adviser’s coverage universe according to a methodology that emphasizes fundamentals such as recurring earnings, cash flows, capital efficiency, capital structure, and valuation;

• Identifying and excluding companies that do not conform to the Adviser’s valuation methodology or companies judged by the Adviser to have questionable financial reporting;

• Updating the analysis for earning releases, annual (Form 10-K) and quarterly (Form 10-Q) reports and other corporate filings;

The origin of the value investing philosophy is traced to two faculty members at Columbia Business School, Benjamin Graham and David Dodd. The two are co-authors of the classic The Security Analysis (1934). Their approach to investing had a lasting practical impact. For one, it had a profound influence on Warren Buffett. By 2024, Berkshire Hathaway became the largest corporate taxpayer in the United States. Buffett is the most celebrated value investor, not only for his track record but also for his extraordinary ability to explain complex business problems in simple language. Yet, he is not alone. In his 1984 essay, The Superinvestors of Graham and Doddsville, published in the Columbia Business School magazine, Buffett introduces a number of his fellow value investors who successfully applied Graham and Dodd’s philosophy.

Accounting information anchors value investing:

"Accounting is the language of business, and you have to be as comfortable with that as you are with your own native language to really evaluate businesses. And accounting tells you a lot, and it can be used in many ways to deceive. You saw it in Enron, for example. … You really have to understand what can be done with accounting when it gives you correct answers and when it gives you wrong answers."

Warren Buffett (March 2, 2015, CNBC Squawk Box show)

Financial statements are central to value investing, but investors need not take reported numbers at face value. Accounting standards, like all regulations, are the byproducts of political tug-of-war. It is therefore critical to understand the key assumptions embedded in the accounting numbers and how to reverse or adjust them when necessary. In some cases, that means placing less weight on reported earnings and focusing instead on underlying cash flows or other metrics that better reflect the fundamentals. For example, according to John Malone, the legendary CEO of TCI, ignoring EPS and focusing on cash flows was key to its success (as detailed in The Outsiders by William Thorndike).

Useful Resources

Value investing combines business analysis with fundamental accounting information to identify potential gaps between intrinsic values and market prices. The following resources provide a helpful intellectual anchor to guide the analysis. I strongly recommend them not only to those interested in value investing but also to corporate managers and entrepreneurs, as they provide a foundation for thinking about value creation and capital allocation.

The Classics

• The Superinvestors of Graham-and-Doddsville (Buffett 1984)

• Common Sense and Uncommon Profits (Fisher 1958, 1996)

• The Intelligent Investor (Graham 1949)

• The Security Analysis (Graham and Dodd 1934) 

Business Analysis & Evaluating Competitive Advantages

• The Essays of Warren Buffett: Lessons for Corporate America (essays & shareholder letters of Buffett curated by Cunningham)

• The Four: The Hidden DNA of Amazon, Apple, Facebook, and Google (Galloway 2018)

• Competition Demystified: A Radically Simplified Approach to Business Strategy (Greenwald and Kahn 2005)

• On the Hunt for Great Companies (Kold 2024)

• The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Thorndike 2012)

Valuation & Applied Value Investing

• Latest Documents from Greenlight Capital at https://www.greenlightcapital.com/

• Narrative and Numbers (Damodaran 2017)

• You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits (Greenblatt 1999)

• The Little Book That Still Beats the Market (Greenblatt 2010)

• Value Investing: From Graham to Buffett and Beyond (Greenwald, Kahn, Sonkin, and Van Biema 2001; Greenwald, Kahn, Bellissimo, Cooper, and Santos 2020)

• Margin of Safety: Risk-averse Value Investing Strategies for the Thoughtful Investor (Klarman 1991)

• Expectations Investing: Reading Stock Prices for Better Returns (Mauboussin and Rappaport 2001, 2021)

• The Dhandho Investor: The Low-Risk Value Method to High Returns (Pabrai 2007)

• Accounting for Value (Penman 2011)

• Financial Statement Analysis for Value Investing (Penman and Pope 2025)

• Pitch the Perfect Investment: The Essential Guide to Winning on Wall Street (Sonkin and Johnson 2017)

Financial Statement Analysis

• Ratio Analysis and Equity Valuation: From Research to Practice (Nissim and Penman 2001)

• Profitability Analysis (Nissim 2022)

• Earnings Quality, Fundamental Analysis and Valuation (Nissim 2025)

• Financial Statement Analysis and Security Valuation (Penman 2012 is the latest edition)

Podcasts & Other Sources

• Bloomberg Masters in Business Podcast (hosted by Barry Ritholtz)

• Columbia Business School Value Investing with Legends Podcast (hosted by Tano Santos and Michael Mauboussin)

• The Footnotes Analyst: Analytical Insights for Investors (maintained by Cooper and Jullens)

Empirical Evidence
Value investing typically centers on stock selection, often through concentrated portfolios. Charlie Munger emphasized this point in his critiques of diversification:

• "Diversification is for the know-nothing investor; it's not for the professional."

• "A lot of people think that if they have a hundred stocks, they're investing more professionally than they are if they have four or five. I regard this as insanity."

Yet value investing has also been supported by large-sample empirical research. Influential studies include:

• Contrarian Investment, Extrapolation, and Risk (Lakonishok, Shleifer, and Vishny 1994)

• Accounting Valuation, Market Expectation, and Cross-sectional Stock Returns (Frankel and Lee 1998)

Chapter 1 of the 2020 edition of [Value Investing: From Graham to Buffett and Beyond] provides further instructive discussion on the validity of value investing. See pages 14-15, Appendix: Is Extra Returns the Reward for Extra Risk?

Credits

I have benefited tremendously from the teaching of accounting faculty at Columbia Business School: Thomas Bourveau (Financial Statement Analysis), Trevor Harris and Shiva Rajgopal (Fundamental Analysis for Investors, Managers, and Entrepreneurs), Doron Nissim (Earnings Quality and Fundamental Analysis), and Stephen Penman (Accounting for Value).

I am also grateful to Christine Cuny (Financial Statement Analysis), from whom I learned Nissim and Penman (2001) during my time as a visiting exchange student at NYU Stern.