What is Abnormal Earnings Valuation?
The abnormal earnings valuation technique evaluates a company’s worth based on two factors, i.e., the book value of the company and its expected earnings. The valuation model looks at the expected profit that can be generated by the management.
If the earnings are higher than expected, an investor would be willing to pay more than the book value, and if it’s not expected to achieve the same, the investor would not be willing to pay anything more than the book value. In fact, he would like to receive the same on discount.
The abnormal earnings valuation method basically helps the investor to determine the potential fair value of a stock. The baseline of the theory is that “every stock is worth the company’s book value if the investors just expect the organization to earn a normal rate of return.” Anything that is under-delivered or over-delivered than the market’s expectation will attribute to “abnormal earnings.”
The discounting factor used should be the return required on equity rather than the weighted average cost of capital. If the second half of the formula is positive, it means that the management is creating value by delivering higher than expected returns for the shareholders.
Value of the Stock = Book Value + Perpetual Value of Future Expected Residual Incomes
- Any company’s potential earnings are generally influenced by the kind of resources (net assets) that is available to management and the latter’s ability to generate a return (profitability) from such assets.
- Any earnings that are higher than the expected return will be called positive abnormal earnings, and any return less than expected return will be termed negative abnormal earnings.
- It is important to generate positive abnormal earnings from a long-term perspective in order to sell at a premium to the book value.
Some of the popular ratios that also need to be compared are:
- Price-to-earnings ratio
- Price-to-book value ratio
- Return on capital employed (ROCE)
- Discounted cash flow (DCF)
- Return on equity (ROE)
The book value per share of ABC Inc. is $100. Suppose the company’s management is able to generate a profit that is higher than the market’s expectation, then the price of the stock will increase above $100 and thus will create more value for shareholders. On the other hand, if the earnings are less than expected, the management will be responsible as the wealth of the shareholders will be diluted.
- Aligned with what market/analyst forecast
- Incorporates the financial statements
- Shows quality of the management
- Focus on value drivers and maximization of shareholders’ wealth
- Accounting complexity can lead to incorrect book value
- Not suitable for companies with a consistent dividend policy
- Similar to DCF, it depends highly on the forecast of business projections
- Forecast horizon can differ among analysts, leading to incorrect judgment
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: