Question

2. What does the phrase sustainable earnings mean? What types of earnings are not sustainable?

3. What are abnormal earnings? Describe the key features of the abnormal earnings approach to valuation.

Answer 1

2. Sustainable earnings are the earnings that are expected to sustain in the future. It is known as permanent earnings.The income obtained from gains on sale of assets ,foreign exchange items are not sustainable as it is a one time gain.

3.Abnormal earnings is the earnings that is generated within a firm, which is different from the normal or expected returns in the company.

The abnormal earnings approach to valuation:

• it determines the value of the equity, which is composed of book value and the present value of the Residual income. The stream of residual income is discounted at the cost of equity.
• This model helps to determine weather the management is generating value in the company which is beyond the book value.
• This model is useful, when the company does not pay dividends otherwise the Dividend discount model would be more useful.
• This model is also based on forecasts, making wrong forecasts can make the results of this model erroneous.