Abnormal earnings valuation model, Financial Management

Abnormal Earnings Valuation Model

Abnormal Earnings Valuation Model is a method to analyse the value of the firm. The value of the firm can be the sum of three components - the original invested capital, the normal rate of return and the abnormal return on invested capital. The equity value of the firm is given as

 

BV0 + S AEt/(1+r)t

where BVt = Book value of equity at beginning of year t

 r = Cost of equity capital

AEt = Expected value of abnormal earnings in year t

       = Projected earnings in yr t -(r * BV of equity at beginning of year t)

            This model is basically a rearrangement of the DCF model. It combines "current value" on the balance sheet with the present value of future "abnormal earnings". It has a few advantages over DCF, the first being its simplicity due to the forecasting of the accounting variables. The terminal value represents only a stream of abnormal earnings beyond the forecast horizon as compared to the forecast of cash flows in the DCF model.

 

This method does have some shortcomings. It is dependent on the initial book value, BV0. Also, the book value fails to account for certain assets that do not generate cash flows. Things like patents, trademarks etc are not accounted for and they may cause the abnormal earnings to persist. Also, the option to back out of a project/business is not included.

Posted Date: 7/25/2012 8:32:01 AM | Location : United States







Related Discussions:- Abnormal earnings valuation model, Assignment Help, Ask Question on Abnormal earnings valuation model, Get Answer, Expert's Help, Abnormal earnings valuation model Discussions

Write discussion on Abnormal earnings valuation model
Your posts are moderated
Related Questions
At 31 July 2010 this instrument meets the definition of a derivative: Small or no initial investment. Its value is dependent on an underlying economic item; exchange ra

State the term- adequate working capital If a firm doesn't have adequate working capital, that is, it doesn't invest sufficient funds in current assets, it can become illiquid

What is risk free rate of return There is a 'risk free rate of return' (also known as time preference rate) which is used to compensate for the loss of not being able to invest

Assume that your company has an equity position in a French firm. Explain the condition under which the dollar/franc exchange rate uncertainty does not comprise exchange exposure f

These types of securities have more than one coupon rate and each subsequent coupon rate is higher (or lower) than the previous coupon rate. For

Determine the term- Time Value of Money If an individual behaves rationally, then he wouldn't equate money in hand today with same value a year from now. As a matter of fact, h

Divestment of company re-organisations Adisinvestment or divestment is selling part of the business or subsidiary to another third party. Reasons and features for divestme

Q. What is Alternative Minimum Tax? Alternative Minimum Tax (AMT) - Tax imposed to back up the regular income tax imposed onCORPORATION and individuals to guarantee that taxpay

Principles of Financial Accounting and Management 1. Define Accounting. Briefly explain the ‘Entity Concept' and ‘Money Measurement Concept' of accounting. 2. What is rectif

lease finance and its types