Suppose two companies A and B with the same current book value of equity and are...

Suppose two companies A and B with the same current book value of equity and are expected to have the same return on equity in the future. However, company A’s book value of equity is expected to grow at a faster rate than company B, under the framework of abnormal earnings model, can we say for certain which company’s total value of equity is higher?

Expert Solution

Abnormal Earnings Model :-

Abnormal Earnings Model is a framework for valuation of the Equity of the company.
This model helps measure the value of the company's equity based on two factors:-

Book Value of equity
Future expected Income.

Where, future expected income refers to the future expected cash flows, discounted at rate of return on equity of the company.

In this case :-

As in the given case, both the company A & B have same book value of equity and also same return on the equity in future,

provided that company A's book value of equity is expected to grow faster than that of company B, we can certainly say that Total value of Equity of company A is higher than the value of Equity of company B.

This is because the abnormal earnings model considers Book value of equity and future earnings for valuation of the equity. So, if two company have same future earnings, then it is very logical that the company having higher book value of equity will get higher valuation of its Equity.

ekkarill92 answered 2 years ago

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