Question

Compare and contrast the valuation of stocks using the residual income valuation model and the abnormal earnings growth model

Answer 1

It is an equity valuation method that the value of a company’s stock equals the present value of future residual incomes discounted at the appropriate cost of equity.

residual income approach, a company’s stock value can be calculated as sum total of its book value and its expected future residual income’s present value which is discounted at cost of equity, r.

Residual income = Net income - equity capital × cost of equity

The abnormal earnings valuation method basically helps the investor to determine the potential fair value of a stock

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

under residual income model the opportunity cost will be included where as in abnormal earnings model doesn't include the factors dependence on receipt your income is more than that of abnormal earnings model