Question

Explain why, empirically, there is mean reversion in AE (abnormal earnings). If you divide the sample into deciles according to scaled current levels of AE, which stocks show the greatest AE persistence?

Answer 1

What is Abnormal Earnings Valuation?

The abnormal earnings valuation technique evaluates a company’s worth based on two factors, i.e., the book value of the company and its expected earnings. The valuation model looks at the expected profit that can be generated by the management.

If the earnings are higher than expected, an investor would be willing to pay more than the book value, and if it’s not expected to achieve the same, the investor would not be willing to pay anything more than the book value. In fact, he would like to receive the same on discount.

The abnormal earnings valuation method basically helps the investor to determine the potential fair value of a stock. The baseline of the theory is that “every stock is worth the company’s book value if the investors just expect the organization to earn a normal rate of return.” Anything that is under-delivered or over-delivered than the market’s expectation will attribute to “abnormal earnings.”

Formula

The discounting factor used should be the return required on equity rather than the weighted average cost of capital. If the second half of the formula is positive, it means that the management is creating value by delivering higher than expected returns for the shareholders.

Value of the Stock = Book Value + Perpetual Value of Future Expected Residual Incomes

Key Concepts

• Any company’s potential earnings are generally influenced by the kind of resources (net assets) that is available to management and the latter’s ability to generate a return (profitability) from such assets.
• Any earnings that are higher than the expected return will be called positive abnormal earnings, and any return less than expected return will be termed negative abnormal earnings.
• It is important to generate positive abnormal earnings from a long-term perspective in order to sell at a premium to the book value.

How to Calculate an Abnormal Earnings Valuation

The abnormal earnings valuation model is one of several methods to estimate the value of stock or equity. There are two components to equity value in the model: A company's book value and the present value of future expected residual incomes.

The formula for the latter part is similar to a discounted cash flow (DCF) approach, but instead of using a weighted average cost of capital (WACC) to calculate the DCF model's discount rate, the stream of residual incomes are discounted at the firm's cost of equity.

What Does the Abnormal Earnings Valuation Model Tell You?

Investors expect stocks to have a "normal" rate of return in the future, which approximates to its book value per share. "Abnormal" is not always a negative connotation, and if the present value of future residual incomes is positive, then company management is assumed to be creating value above and beyond the stock's book value.

However, if the company reports earnings per share that comes in below expectations, then management will take the blame. The model is related to the economic value added (EVA) model in this sense, but the two models are developed with variations.

Example of Using the Abnormal Earnings Valuation Model

The model may be more accurate for situations where a firm does not pay dividends, or it pays predictable dividends (in which case a dividend discount model would be suitable), or if future residual incomes are difficult to forecast. The starting point will be book value; the range of total equity value after adding the present value of future residual incomes would thus be narrower than, say, a range derived by a DCF model.

However, like the DCF model, the abnormal earnings valuation method still depends heavily on the forecasting ability of the analyst putting the model together. Erroneous assumptions for the model can render it largely useless as a way to estimate the equity value of a firm.

Limitations of the Abnormal Earnings Valuation Model

Any valuation model is only as good as the quality of the assumptions put into the model. In the case of the book value per share used in the abnormal earnings valuation, a company's book value can be affected by events such as a share buyback and this must be factored into the model. Additionally, any other events that affect the firm's book value must be factored in to make sure the results of the model are not distorted.