Abnormal Earnings Valuation Model – Definition

Cite this article as:"Abnormal Earnings Valuation Model – Definition," in The Business Professor, updated September 21, 2019, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/abnormal-earnings-valuation-model-definition/.


Abnormal Earnings Valuation Model Definition

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. Thi 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.

Reference for “Abnormal Earnings Valuation Model”

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Abnormal Earnings Valuation Model

Earnings, book values, and dividends in equity valuation, Ohlson, J. A. (1995). Contemporary accounting research, 11(2), 661-687. This article creates and analyzes a model of a firm’s market value as it associates to contemporaneous and future earnings, book values, and dividends. This model satisfies many appealing properties and presents an important benchmark when one conceptualizes how the market value relates to accounting data and other information.

An empirical assessment of the residual income valuation model, Dechow, P. M., Hutton, A. P., & Sloan, R. G. (1999). Journal of accounting and economics, 26(1-3), 1-34. This paper presents an empirical assessment of the residual income valuation model. It states that the current empirical research relying on this model is the same as that of past research relying explicitly on the dividend-discounting model. The paper establishes that the critical original practical implications of the model arise from the information dynamics that link current information to future residual income.

Comparing the accuracy and explainability of dividend, free cash flow, and abnormal earnings equity value estimates, Francis, J., Olsson, P., & Oswald, D. R. (2000). Journal of accounting research, 38(1), 45-70. This study presents empirical evidence on the reliability of intrinsic value estimates that result from three equivalent valuation models. It uses Value Line annual forecasts of the elements contained in these models to calculate value estimates for a sample of publicly traded firms accompanied by Value Line between 1989 and 1993.

Linear accounting valuation when abnormal earnings are AR (2), Callen, J. L., & Morel, M. (2001). Review of Quantitative Finance and Accounting, 16(3), 191-204. This paper solves the Ohlson model directly from an AR (2) abnormal earnings dynamic. The model is estimated on a firm-level time series basis following the approach used by Myers. However, it is found that this model significantly underestimates market prices even relative to book values. The results question the empirical validity of the Ohlson model.

Residual earnings valuation with risk and stochastic interest rates, Feltham, G. A., & Ohlson, J. A. (1999The Accounting Review, 74(2), 165-183. This article presents a general version of the accounting-based valuation model that equates the market value of a firm’s equity to book value together with the present value of expected abnormal earnings. The general analysis in the paper is based on two assumptions which are no arbitrage in financial markets and clean surplus accounting.

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