What it means
The starting point is that a business only creates value when it earns more than the return investors could get elsewhere for the same risk. Reported profit ignores that hurdle entirely, because accounting rules charge interest on debt but never charge for the use of shareholders' money.
Abnormal earnings, sometimes called residual income, fix that by deducting a capital charge from net income. The capital charge is the cost of equity multiplied by the book value of equity at the start of the period.
Subtract it from net income and what remains is genuine economic profit: the amount by which the business beat what its owners required. A company earning exactly its cost of equity has zero abnormal earnings and is worth precisely its book value.
Valuing a business then becomes book value plus the discounted stream of those abnormal earnings. This is appealing because a large part of the answer, book value, comes straight from the balance sheet rather than from a long forecast, which makes the model less sensitive to terminal value assumptions than a standard discounted cash flow.
It is particularly useful for banks and insurers, where cash flow is hard to define and regulatory capital is central, and for companies that pay no dividend, which makes dividend-based models useless. Analysts also like it because forecasting earnings is usually more natural than forecasting free cash flow.
The model does depend on the accounting being consistent, specifically on the clean surplus relation, which requires that book value only changes through profit and dividends. Where large gains bypass the income statement and go straight to reserves, the numbers need adjusting before the model can be trusted.
In practice
Real-world examples.
Example
An analyst covering a regional bank that retains all its profits uses the residual income model because dividend discount methods produce no meaningful answer. Book value is reliable for a bank, so most of the valuation rests on solid ground.
Example
A private investor comparing two identical-looking retailers finds one trades near book value and the other at twice book value. Working through abnormal earnings shows the premium is justified only if the second company sustains a return on equity roughly six points above its cost of equity for a decade.
Example
A board reviewing a divisional performance scheme replaces a profit target with a residual income target after realising managers were being rewarded for growing the asset base regardless of the return it earned.
Formula
Calculation
Value of equity = opening book value + sum of the present value of abnormal earnings, where abnormal earnings for a year = net income - (cost of equity x opening book value of equity).
A specialist engineering firm has opening book value of equity of $40,000,000 and a cost of equity of 10%, so the annual capital charge is $40,000,000 x 0.10 = $4,000,000. Assume it pays out all its earnings as dividends, so book value stays at $40,000,000, and forecast net income of $6,000,000, $6,600,000 and $7,200,000 over the next three years, after which competition erodes any excess return to zero.
Abnormal earnings are $6,000,000 - $4,000,000 = $2,000,000 in year one, $6,600,000 - $4,000,000 = $2,600,000 in year two, and $7,200,000 - $4,000,000 = $3,200,000 in year three. Discounting at 10% gives $2,000,000 / 1.10 = $1,818,182, then $2,600,000 / 1.21 = $2,148,760, then $3,200,000 / 1.331 = $2,404,207, a total of $6,371,149.
Value of equity is therefore $40,000,000 + $6,371,149 = $46,371,149, or about 1.16 times book value. The premium above book value exists entirely because the firm is forecast to out-earn its 10% hurdle for three years.Case study
Seen in the real world.
Larkfield Instruments is a fictional company used here for illustrative purposes. Its share price had drifted for years despite steadily rising reported profits, and the board could not understand why the market seemed unimpressed by consistent earnings growth.
An adviser worked through the abnormal earnings arithmetic. Larkfield's net income had grown roughly 5% a year, but equity had grown faster because the company retained everything it earned and invested it in a low-return service division. With a cost of equity of 9% and a return on equity of about 8%, abnormal earnings were slightly negative, which explained precisely why the shares traded a little below book value.
Larkfield sold the service division, returned $60m to shareholders through a buyback and concentrated capital in its instruments business, which earned around 15%. Within two years abnormal earnings turned solidly positive and the shares moved to a premium. The illustrative point is that growth in profit means nothing unless it beats the cost of the capital used to produce it.
Watch out
Common mistakes.
- Forgetting the capital charge entirely and concluding that any profitable company is creating value, when profit below the cost of equity destroys it.
- Using the closing rather than the opening book value of equity when calculating the capital charge, which double counts the year's own earnings.
- Assuming abnormal earnings can be forecast indefinitely, when competition normally erodes excess returns within five to ten years in most industries.
Questions
People also ask.
How does this differ from discounted cash flow?
Both should give the same answer in theory, but this model anchors on book value and forecast earnings rather than on free cash flow and a large terminal value.
What is the clean surplus relation?
It is the requirement that book value changes only through net income and dividends, so gains that bypass the income statement must be adjusted for before applying the model.
Is it the same as economic value added?
The logic is essentially the same, though economic value added charges for all invested capital using the weighted average cost of capital, while this model charges only for equity.
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