Question

What does the phrase sustainable earnings mean? What types of earnings are not sustainable? What are abnormal earnings? Briefly describe the key features of the abnormal earnings approach to valuation.

Answer 1

Phrase sustainable earnings meaning

The sustainable earning are those reported income that are most likely to be earned by the company after giving effect of tax of all non recurring expenses , loss and gains that are unlikely to be accounted every year . Most likely the sustainable income is derived from the operational income sources .

Types of earnings that are not sustainable

• Non business income and non business expenses.
• Abnormal income and abnormal expenses .
• Transistory losses or expenses or incomes .
• Discontinued operation or extra ordinary items .

Abnormal earnings

Abnormal earnings connotation means the extra earning / under performance over the expected return projected . The abnormal earning capacity of the firm /company depends on the managment decision making .

Positive Abnormal earning = Firm current earning > Cost of Capital

Negative Abnormal earning = Firm current earning < Cost of Capital

The key features of the abnormal earnings approach to valuation.

1. The company's earnings of future are forecasted over a specific period say 5 years.
2. The expected earning i.e the earning on derived cost of capital is subtracted from the forecated earning ( as mentioned in step 1 ) to arrive at abnormal earning of the specified period .
3. Next step is to develop post horizon abnormal earning based on the eatimated terminal value of the company / firm .
4. Using the expected cost of capital discounting rate, the abnormal earning over the period are discounted .