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.