15.4 Abnormal Earnings (AE)

Works with accounting measures of income

  • Need to remove distortions

  • Some same it is more accurate

Clean surplus assumption

  • Requires all changes to book value (on the b/s) flow through the I/S (as earnings, dividends, or capital contributions/reductions)

  • Can’t have direct changes to equity

Value of Equity

\[\begin{equation} V_0 = BV_0 + \sum_{t=1} \dfrac{AE_t}{(1+k)^t} \tag{15.4} \end{equation}\]

Abnormal Earning @ \(t\)

\[\begin{equation} AE_t = NI_t - k \cdot BV_{t-1} = (ROE_t - k)BV_{t-1} \tag{15.5} \end{equation}\]

  • Earnings (net income) XS of cost of capital

  • Assume AE will trend to zero overtime since it’s difficult to maintain

  • AE is difficult to maintain as competitors will see the AE and move into the market

Parameters Considerations

Remark. \(BV_0\)

  • Reported book value

  • Focus on tangible book value (e.g. take out goodwill)

  • Remove any systematic bias such as over or understated reserve

Remark. \(NI\) is net of interest payments to shareholders, after tax; Same as DCF model

  • Make complement of the book value adjustments here
    e.g. any direct adjustment to the B/S that doesn’t flow from the I/S you have to adjust here

  • If reserve is discounted in the \(BV_0\), need to change (lower) the \(ROE\) as the income will be generated from a larger capital base

Remark. \(g\)

  • Should be negative as AE tend to 0

  • Does not require additional capital as the growth from that extra capital will not accrue to today’s shareholders

Remark. \(k\)

  • CAPM as before

Advantages

  • Focus on value creation

    • Earnings above the required return on capital

    • Dividends and CF are just consequence of value creation

  • Small terminal value as it focus on any added value so less leverage

  • Directly using accounting measures so does not need to adjust into a cash flow measure