The Penman-Nissim model of profitability analysis


Stephen Penman is a George O. May Professor of Financial Accounting at Columbia Business School. He is the author and co-author of acclaimed financial valuation textbooks, such as Financial Statement Analysis and Security Valuation as well as books aimed at a more general audience, such as Accounting for Value

The Penman-Nissim Profitability Framework

In 1999, Doron Nissin and Stephen Penman published a paper that proposes the analysis of certain profitability ratios, for use in equity valuation. The paper is divided into two main parts.

  • First, it identifies ratios that are useful for valuation.
  • Second, it documents typical values of the ratios during the period 1963 to 1996.

Analysing returns (ROA, ROE, RNOA)

The main strength of the Penman-Nissim model is its emphasis on trying to add more clarity to the source of profitability. Essentially, when using the Penman-Nissim model of Profitability, the user splits financial assets and liabilities away from the operating assets and liabilities. In the same way, earnings are dissected and split into free cash flow from operations and other comprehensive income.

Once the analyst has made the distinction between the operations and the non-operational assets, he is also able to assess the profitability of the operations of the company. As is often the case, companies with redundant non-core assets, such as excess cash balances, will not show up in screens of profitable companies, even though they are. An example of this is the Winland Holdings and Arion Bank. In many cases, dormant assets are a predictive attribute of outperformance.

Return on Equity

ROE is an important metric used to help judge how well a firm is turning shareholders’ invested capital into earnings. Breaking ROE down into a series of ratios can be even more telling, as it adds precision to the analysis by showing just how a firm is achieving its overall ROE. The Penman-Nissim framework complements other means of profitability analysis because it gives a clear and accurate picture of a firm’s core operating profitability and its use of leverage. (For more, see Profitability Indicator Ratios: Return On Equity.)

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