Abnormal earnings valuation model: Meaning, Criticisms & Real-World Uses

What Is Abnormal Earnings Valuation Model?

The abnormal earnings valuation model (AEVM), often referred to interchangeably with the residual income model (RIM), is an equity valuation technique that determines a company's intrinsic value by adding the current book value of equity to the present value of its expected future abnormal earnings. This model falls under the broader category of financial modeling and focuses on the earnings a company generates beyond what is required to compensate its shareholders for the capital they have invested. Abnormal earnings represent the profit left over after deducting a charge for the use of equity capital, providing insight into a firm's true economic profit.

History and Origin

The foundational concepts underlying the abnormal earnings valuation model can be traced back several decades. Early work by accounting theorists such as Edgar O. Edwards and Philip W. Bell in their 1961 book, The Theory and Measurement of Business Income, laid important groundwork for understanding income concepts beyond traditional accounting profits⁶. They explored various dimensions of a firm's performance, emphasizing that different profit measures could be relevant for different analytical purposes.

However, the modern abnormal earnings valuation model, particularly its widespread recognition in academia and practice, is largely attributed to Professor James Ohlson's seminal 1995 paper, "Earnings, Book Values, and Dividends in Equity Valuation." Ohlson's work provided a rigorous mathematical framework that formally linked a firm's market value to its accounting fundamentals, specifically its book value and abnormal earnings⁵. This formalization made the abnormal earnings valuation model a powerful tool for analysts seeking to understand a company's underlying value creation.

Key Takeaways

The abnormal earnings valuation model values a company by combining its current book value of equity with the discounted value of its future abnormal earnings.
Abnormal earnings are calculated as the reported net income minus a charge for the cost of equity capital.
This model is particularly useful for valuing companies that do not pay dividends or have unpredictable cash flows.
The model assumes the adherence to the clean surplus accounting relation, where all changes in book value are explained by net income and dividends.
The abnormal earnings valuation model provides a framework to assess whether a company is generating value above its capital costs, aligning with the concept of shareholder value maximization.

Formula and Calculation

The abnormal earnings valuation model states that the intrinsic value of a company's equity today ($V_0$) is equal to its current book value of equity per share ($B_0$) plus the present value of all expected future abnormal earnings.

First, abnormal earnings ($AE_t$) for a given period (t) are calculated as:

AE_t = E_t - (r \times B_{t-1})

Where:

$E_t$ = Expected earnings per share in period (t)
$r$ = Required return on equity (cost of equity capital)
$B_{t-1}$ = Book value of equity per share at the end of the previous period ((t-1))

The valuation formula for the abnormal earnings valuation model is then:

V_0 = B_0 + \sum_{t=1}^{\infty} \frac{AE_t}{(1 + r)^t}

Where:

$V_0$ = Intrinsic value of equity per share today
$B_0$ = Current book value of equity per share
$AE_t$ = Expected abnormal earnings per share in period (t)
$r$ = Required rate of return on equity (the discount rate)

In practice, forecasts for abnormal earnings are typically made for a finite number of periods, and a terminal value is estimated for periods beyond the explicit forecast horizon.

Interpreting the Abnormal Earnings Valuation Model

Interpreting the abnormal earnings valuation model involves understanding what constitutes "abnormal" profitability and how it contributes to a company's value. When a company's actual earnings exceed the normal return required by its equity investors—that is, its cost of equity multiplied by the beginning book value of equity—it generates positive abnormal earnings. These positive abnormal earnings indicate that the company is creating value for its shareholders above and beyond simply covering its capital costs. Conversely, consistently negative abnormal earnings suggest that the company is destroying shareholder value, as its returns do not adequately compensate equity investors.

Analysts use the abnormal earnings valuation model to gauge a company's ability to sustain competitive advantages. A business that can consistently generate positive abnormal earnings typically possesses strong intangible assets, efficient operations, or a dominant market position. The model highlights that value creation is not merely about generating profits, but about generating profits in excess of the capital required to achieve them. This perspective encourages a focus on efficient capital allocation and profitability that surpasses the minimum acceptable hurdle rate for equity investors, often derived using techniques like the Capital Asset Pricing Model.

Hypothetical Example

Consider Tech Innovations Inc., a publicly traded company. As of the end of 2024, its book value of equity per share ($B_0$) is $50. Investors require a 10% annual return on their equity (r = 0.10).

Tech Innovations Inc. is expected to have the following earnings per share (EPS) for the next three years:

Year 1 (2025): EPS = $6.00
Year 2 (2026): EPS = $6.50
Year 3 (2027): EPS = $7.00

Let's calculate the abnormal earnings for each year:

Year 1 (2025):

Expected normal earnings = $r \times B_0 = 0.10 \times $50.00 = $5.00$
Abnormal Earnings ($AE_1$) = $E_1 - (r \times B_0) = $6.00 - $5.00 = $1.00$

Year 2 (2026):
First, we need the book value at the end of Year 1 ($B_1$). Assuming a simple clean surplus accounting relation where no dividends are paid for simplicity ($B_t = B_{t-1} + E_t$):

$B_1 = B_0 + E_1 = $50.00 + $6.00 = $56.00$
Expected normal earnings = $r \times B_1 = 0.10 \times $56.00 = $5.60$
Abnormal Earnings ($AE_2$) = $E_2 - (r \times B_1) = $6.50 - $5.60 = $0.90$

Year 3 (2027):

$B_2 = B_1 + E_2 = $56.00 + $6.50 = $62.50$
Expected normal earnings = $r \times B_2 = 0.10 \times $62.50 = $6.25$
Abnormal Earnings ($AE_3$) = $E_3 - (r \times B_2) = $7.00 - $6.25 = $0.75$

Now, we calculate the present value of these abnormal earnings:

PV of $AE_1 = \frac{$1.00}{(1 + 0.10)^1} = \frac{$1.00}{1.10} \approx $0.91$
PV of $AE_2 = \frac{$0.90}{(1 + 0.10)^2} = \frac{$0.90}{1.21} \approx $0.74$
PV of $AE_3 = \frac{$0.75}{(1 + 0.10)^3} = \frac{$0.75}{1.331} \approx $0.56$

Assuming that after Year 3, abnormal earnings are expected to cease (a simplified assumption for this example), the intrinsic value of Tech Innovations Inc. per share ($V_0$) would be:

$V_0 = B_0 + PV(AE_1) + PV(AE_2) + PV(AE_3)$
$V_0 = $50.00 + $0.91 + $0.74 + $0.56 = $52.21$

Based on this abnormal earnings valuation model, the intrinsic value of Tech Innovations Inc. is approximately $52.21 per share.

Practical Applications

The abnormal earnings valuation model is widely applied in various areas of financial analysis and investment decision-making. Investors and analysts use it to determine the fundamental value of a company's stock, particularly when other valuation methods may be less suitable. For instance, the model proves effective for valuing companies that do not pay dividends, as it does not rely on dividend forecasts. It is also well-suited for firms with unstable or negative free cash flow, where a discounted cash flow approach might be challenging to implement.

B⁴eyond equity valuation, the abnormal earnings framework is useful for internal corporate performance measurement. Companies may use the concept to evaluate business units or projects, assessing whether they are generating returns above their respective cost of equity and thus contributing positively to overall shareholder value. The emphasis on economic profit rather than just accounting profit encourages management to make decisions that truly enhance the wealth of shareholders. The CFA Institute, for example, highlights the utility of residual income models not only for equity valuation but also for measuring internal corporate performance and for determining executive compensation.

#³# Limitations and Criticisms

Despite its theoretical appeal and practical utility, the abnormal earnings valuation model has several limitations. A primary concern is its reliance on accounting data, which can be susceptible to manipulation or require significant adjustments to accurately reflect economic reality. Th²e quality of reported net income and book value of equity is crucial, and differing accounting policies across companies or industries can impair comparability. For instance, the model typically assumes adherence to the clean surplus accounting relation, where all changes in book value are attributable to earnings and dividends. In practice, deviations from clean surplus, such as items recognized in other comprehensive income, may necessitate adjustments.

Furthermore, forecasting future abnormal earnings can be challenging. Like other forward-looking valuation models, the accuracy of the abnormal earnings valuation model's output is highly sensitive to the assumptions made about future profitability, growth rates, and the chosen discount rate. Long-term forecasts inherently carry a high degree of uncertainty, and small changes in these inputs can lead to significant variations in the estimated intrinsic value. While the model may be less sensitive to distant terminal value estimates compared to discounted cash flow models, it still requires robust projections of future financial performance over the explicit forecast period.

#¹# Abnormal Earnings Valuation Model vs. Discounted Cash Flow (DCF) Model

The abnormal earnings valuation model (AEVM) and the discounted cash flow model (DCF) are both prominent methods in equity valuation, yet they approach valuation from different perspectives. While the DCF model values a company based on the present value of its expected future free cash flows, the AEVM focuses on accounting profits that exceed the charge for equity capital.

The core difference lies in their starting points and what they define as value-generating. DCF models directly discount cash flows available to investors (either free cash flow to firm or free cash flow to equity). In contrast, the abnormal earnings valuation model begins with the current book value of equity and adds the present value of "abnormal" profits—those earnings generated above and beyond the cost of using the company's equity capital. Both models, when applied correctly with consistent assumptions, should theoretically yield the same intrinsic value. However, in practice, they can produce different results due to varying assumptions, particularly regarding growth and the treatment of certain accounting items. The AEVM's reliance on book value and the accounting income statement can make it more intuitive for users familiar with financial statements, and it may be more appropriate for companies with volatile or negative cash flows.

FAQs

What are abnormal earnings?

Abnormal earnings, also known as residual income, are the earnings a company generates that exceed the normal profit required to compensate its equity investors for the use of their capital. This "normal profit" is calculated as the cost of equity multiplied by the beginning book value of equity.

Why use the abnormal earnings valuation model instead of other methods?

The abnormal earnings valuation model is particularly useful for valuing companies that do not pay dividends, have unpredictable cash flows, or when a significant portion of a company's value is embedded in its current book value. It focuses on economic profit and can be less sensitive to distant terminal value estimates than some other models.

How does the cost of equity factor into the model?

The cost of equity is a critical input in the abnormal earnings valuation model. It represents the required rate of return that shareholders expect for their investment, considering the risk involved. This rate is used to calculate the "normal" earnings charge that is subtracted from reported earnings to arrive at abnormal earnings, and also serves as the discount rate for future abnormal earnings.