What Is Abnormal Earnings?
Abnormal earnings, also known as residual income or economic earnings, represent the profit a company generates that exceeds its expected or "normal" return on capital invested57, 58, 59. It is a key concept in financial analysis and valuation, particularly within the realm of equity valuation. These earnings are considered "abnormal" because they deviate from the profits anticipated based on the company's assets, liabilities, and the cost of its capital55, 56. Positive abnormal earnings suggest that a company is creating value above and beyond what is required to satisfy its investors, while negative abnormal earnings indicate underperformance53, 54.
History and Origin
The concept of abnormal earnings gained prominence with the development of accounting-based valuation models. A seminal work in this area is the Ohlson (1995) valuation model, which explicitly links a company's stock value to its book value and expected future abnormal earnings50, 51, 52. This model, also known as the residual income model, provided a mathematical framework for understanding how accounting numbers relate to market prices. While the idea of "excess profits" or "super-profits" existed prior, Ohlson's work formalized the use of abnormal earnings in a robust valuation context, significantly influencing subsequent theoretical and empirical research in financial analysis48, 49.
Key Takeaways
- Abnormal earnings are the profits a company earns above its required return on equity.
- They are a core component of the residual income model for equity valuation.
- Positive abnormal earnings suggest a company is creating value for shareholders.
- The concept helps analysts assess a company's true financial performance beyond reported net income.
- Accurate forecasting of future earnings is crucial for effective use of abnormal earnings in valuation.
Formula and Calculation
Abnormal earnings are calculated by subtracting the equity charge (cost of equity capital) from a company's net income47. This metric aims to show the profit generated beyond the minimum return required by equity investors46.
The formula for abnormal earnings (AE) is:
Where:
- (AE) = Abnormal Earnings
- (Net Income) = The company's profit after all expenses, interest, and taxes.
- (Cost of Equity) = The rate of return required by equity investors (often calculated using the Capital Asset Pricing Model).
- (Book Value of Equity) = The total value of a company's assets minus its liabilities, as recorded on its balance sheet.
Alternatively, the "equity charge" can be viewed as the expected earnings44, 45.
Interpreting the Abnormal Earnings
Interpreting abnormal earnings provides valuable insights into a company's financial health and management effectiveness. Positive abnormal earnings indicate that a company is generating profits in excess of its cost of capital, implying that management is effectively utilizing shareholder funds to create additional value42, 43. This can be a sign of a strong competitive advantage or an efficient business model41.
Conversely, consistently negative abnormal earnings suggest that a company is not earning enough to cover its cost of equity, potentially destroying shareholder value40. This might signal underlying operational inefficiencies, intense competition, or poor capital allocation decisions39. Analysts often compare a company's abnormal earnings to those of its industry peers to gauge relative performance38. However, it is essential to consider various factors and limitations, as positive abnormal earnings resulting from temporary factors or accounting manipulations may not be sustainable37. The model implicitly attributes the portion of a stock's market price that deviates from its book value to the quality of a company's management expertise36.
Hypothetical Example
Let's consider a hypothetical company, "InnovateTech Inc."
- InnovateTech Inc.'s Net Income for the year: $50 million
- InnovateTech Inc.'s Book Value of Equity at the beginning of the year: $400 million
- The estimated Cost of Equity for InnovateTech Inc.: 10%
First, calculate the expected earnings or the equity charge:
Expected Earnings = Cost of Equity × Book Value of Equity
Expected Earnings = 0.10 × $400 million = $40 million
Next, calculate the abnormal earnings:
Abnormal Earnings = Net Income - Expected Earnings
Abnormal Earnings = $50 million - $40 million = $10 million
In this scenario, InnovateTech Inc. has generated $10 million in positive abnormal earnings. This suggests that the company's management has effectively utilized its equity capital to produce returns exceeding the minimum required by its investors. This positive abnormal earnings figure would contribute to a higher intrinsic value for InnovateTech Inc. when using the residual income valuation model.
Practical Applications
Abnormal earnings are widely applied in financial analysis and investment decision-making. Investors use this metric to identify companies that consistently outperform the market and potentially offer above-average returns. 35It is a central component of several valuation models, particularly the residual income model, which values a company based on its book value and the present value of its future abnormal earnings.
33, 34
Financial analysts often incorporate abnormal earnings into their valuation models to provide more accurate forecasts and recommendations. 31, 32The concept helps them assess whether a company's stock is undervalued or overvalued by comparing its intrinsic value (derived partly from abnormal earnings) to its current market price. 29, 30Moreover, understanding abnormal earnings can aid in identifying potential income smoothing practices, where companies might manipulate reported earnings to present a more consistent financial performance. 28Regulators, such as the U.S. Securities and Exchange Commission (SEC), emphasize transparent and fair financial reporting, which indirectly influences the reliability of abnormal earnings as an indicator of performance.
Limitations and Criticisms
Despite its utility, the abnormal earnings valuation model, like any financial model, has limitations and faces criticisms. A primary concern is its heavy reliance on accurate forecasting of future earnings, which can be challenging and prone to errors. 26, 27Inaccuracies in these forecasts can lead to inaccurate valuations. 25The model also assumes that earnings will eventually revert to a long-term average, which may not always hold true, especially for companies in rapidly changing industries.
24
Another limitation is the model's sensitivity to assumptions made about variables such as the cost of capital and expected growth rates; minor changes in these assumptions can significantly impact the valuation. 23Identifying and measuring abnormal earnings accurately can also be difficult in practice, requiring a deep understanding of the company's industry and competitive landscape, along with detailed analysis of its financial statements.
22
Furthermore, the model may not be suitable for all companies, particularly those with high levels of intangible assets or those with negative book equity, such as some startups. 20, 21Some critics argue that the model focuses solely on financial factors, potentially overlooking important non-financial elements like management quality or broader industry trends. 19The "clean surplus accounting" assumption, which implies that all equity effects (except capital transactions) flow through the income statement, often does not hold perfectly in practice, though the model can still be appropriate as deviations are expected to average out.
18
Abnormal Earnings vs. Economic Value Added
While often used interchangeably, abnormal earnings (also known as residual income) and Economic Value Added (EVA) are distinct but related concepts, both belonging to the broader category of value-based management metrics. Abnormal earnings, in the context of the residual income model, specifically measure the excess of a company's net income over the equity charge, which is the cost of equity multiplied by the book value of equity. 17It focuses on the return generated for equity holders above their required rate of return.
Economic Value Added, on the other hand, is a trademarked term by Stern Stewart & Co. and typically measures the profit remaining after accounting for the cost of all capital, both debt and equity. 15, 16The formula for EVA is Net Operating Profit After Tax (NOPAT) minus the capital charge, where the capital charge is the weighted average cost of capital (WACC) multiplied by the total invested capital. While both aim to quantify value creation beyond a minimum return, EVA provides a more comprehensive view by considering the cost of the entire capital structure, whereas abnormal earnings, in its fundamental definition for equity valuation, focuses specifically on the return to equity.
FAQs
What is the significance of positive abnormal earnings?
Positive abnormal earnings indicate that a company is generating profits that exceed the minimum return required by its equity investors. 14This suggests that the company's management is effectively creating value and utilizing its capital efficiently.
13
Can abnormal earnings be negative?
Yes, abnormal earnings can be negative. 12Negative abnormal earnings mean that a company's actual earnings are less than the expected earnings based on its cost of equity and book value of equity. This indicates that the company is not generating sufficient returns to cover its cost of capital, potentially destroying shareholder value.
11
How do abnormal earnings differ from net income?
Net income is a company's total profit after all expenses, including taxes and interest, have been deducted. 10Abnormal earnings, however, go a step further by subtracting the cost of equity from the net income, thereby measuring the profit above what is considered a normal or expected return for equity investors. 8, 9Net income is an absolute measure of profit, while abnormal earnings are a measure of "excess" profit relative to the cost of equity capital.
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Is abnormal earnings the same as economic profit?
Abnormal earnings are often used synonymously with economic profit or economic earnings. 4, 5, 6Both concepts refer to the profit generated by a company that exceeds its opportunity cost of capital.
How are abnormal earnings used in stock valuation?
Abnormal earnings are a critical input in the Abnormal Earnings Valuation Model, also known as the residual income model. This model calculates a company's intrinsic value by adding its current book value of equity to the present value of all its expected future abnormal earnings. 2, 3It suggests that if a company consistently generates positive abnormal earnings, its stock price should trade above its book value.1