What is the 'Abnormal Earnings Valuation Model'

The abnormal earnings valuation model is a method for determining a company's equity value based on book value and earnings. Also known as the residual income model, it looks at whether management's decisions cause a company to perform better or worse than anticipated. The model concludes that investors should pay more than book value if earnings are higher than expected and less than book value if earnings are lower than expected.

BREAKING DOWN 'Abnormal Earnings Valuation Model'

The abnormal earnings valuation model is one of several methods to estimate the value of equity. There are two components to equity value in the model: book value and the present value of future expected residual incomes. The formula for the latter part is similar to a discounted cash flow (DCF) approach, but instead of a weighted average cost of capital (WACC) for the discount rate, the stream of residual incomes are discounted at the firm's cost of equity. "Abnormal" is not a negative connotation. If the present value of future residual incomes is positive, then management of the company is creating value above and beyond book value of the firm. The model is related to the Economic Value Added (EVA) model in this sense, but the two models are developed with variations.

When to Use the Abnormal Earnings Valuation Model

The model may be more accurate for situations where a firm does not pay dividends or predictable dividends (in which case a dividend discount model would be suitable) or if future residual incomes are difficult to forecast. The starting point will be book value; therefore, the range of total equity value after adding the present value of future residual incomes would be narrower than, say, a range derived by a DCF model. However, like the DCF model, the abnormal earnings valuation method still depends heavily on the forecasting ability of the analyst putting the model together. Erroneous assumptions for the model can render it largely useless as a way to estimate equity value of a firm.

RELATED TERMS
  1. Abnormal Return

    A term used to describe the returns generated by a given security ...
  2. Business Valuation

    Business valuation is the process of determining the economic ...
  3. Valuation

    A valuation is the process of determining the current worth of ...
  4. Model Risk

    Model risk occurs when a financial model used to measure a firm's ...
  5. Relative Valuation Model

    A relative valuation model is a business valuation method that ...
  6. Dividend Discount Model - DDM

    The dividend discount model (DDM) is a system for valuing the ...
Related Articles
  1. Personal Finance

    Discounted cash flows or comparables: Which to use

    DCF and comparables models are widely used in equity valuation, and here we'll explain the pros and cons of each method.
  2. Financial Advisor

    Is Texas Instruments a Good Value Play? (TXN)

    Find out whether investors and analysts believe that Texas Instruments would make a good value play at its current valuation, and learn more about its outlook.
  3. Investing

    What Is The Intrinsic Value Of A Stock?

    Intrinsic value reduces the subjective perception of a stock's value by analyzing its fundamentals.
  4. Investing

    Top 3 Pitfalls Of Discounted Cash Flow Analysis

    Find out why the Discounted Cash Flow (DCF) method can be difficult to apply to real-life valuations.
  5. Investing

    Digging Into The Dividend Discount Model

    The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions.
  6. Investing

    Financial Models You Can Create With Excel

    The relatively modest amount of time it takes to build these models can pay for itself by leading you to better investment decisions.
  7. Investing

    Book Value: How Reliable Is It For Investors?

    In theory, a low P/B ratio means you have a cushion against poor performance. In practice, it is much less certain.
  8. Investing

    Equity Valuation In Good Times And Bad

    Learn how to filter out the noise of the market place in order to find a solid way of determing a company's value.
  9. Small Business

    Valuing Startup Ventures

    Valuing a company is a difficult task, regardless of the size of the business - but these methods can help.
RELATED FAQS
  1. How is residual value of assets taxed?

    Find out how and when taxes are assessed on the different kinds of residual value, including the residual value on a leased ... Read Answer >>
  2. How does the dividend discount method (DDM) work?

    Learn about the dividend discount model and when it can most appropriately be used to measure the value of a stock by fundamental ... Read Answer >>
  3. What is the difference between residual income and passive income?

    Learn how passive income helps pay the bills with little work involved. Determine how residual income affects your ability ... Read Answer >>
  4. What is the difference between financial forecasting and financial modeling?

    Understand the difference between financial forecasting and financial modeling, and learn why a company should conduct both ... Read Answer >>
  5. How is terminal value discounted?

    Find out why investors use the terminal value, why the terminal value is discounted to the present day, and how it relates ... Read Answer >>
Trading Center