What is the Abnormal Earnings Valuation Model?

The abnormal earnings valuation model is also called the residual income model. This is an accounting model used in evaluating the financial status of a company. This valuation model determines the equity value that a company owns based on the company's earnings and its book value. When evaluating the financial position of a company using the abnormal earnings valuation model, the revenues and income (earnings) of the company must be considered. This model estimates the net asset value of a company in relation to whether management's decisions positively affect the financial status or otherwise.

How to Calculate an Abnormal Earnings Valuation

To calculate the value of a company using the abnormal earnings valuation model, the formula used is like that of a DCF model (Discounted cash flow), the only difference is that the residual income of the company is discounted at the company's cost of equity. The residual income refers to the amount of income left in the company after all debts and expenses have been cleared. The abnormal earnings valuation model is an accounting method that seeks to find out the value of equity or stock owned by a company. It estimates the equity value using the book value and earnings (income.)

What Does the Abnormal Earnings Valuation Model Tell You?

Using the abnormal earnings valuation model, it is easy to spot whether management's decisions are positively affecting the company's performance or causing a setback to the company. However, checking the abnormal rate of return in a company does not necessarily mean in a negative way, it also reflects earnings that are positive or beyond what is expected. The abnormal earnings valuation model reflects the financial position of a company based on book value and earnings. A positive residual income mean that the company creates more value than its book value while a negative residual income reflects income below the expectations of investors.