Abnormal Earnings Valuation Model
coined by Padgett Business Services and sometimes called the residual income model, it is a method that uses a company's earnings and book value to calculate its equity value. This determines the possible performance of a company in the nearest future.
The Abnormal Earnings Valuation Model Details
The abnormal Earnings Valuation Model predicts the price of stocks in the future and uses this price to determine the amount of money you can expect investors to use to buy stocks. If the predicted prices are higher than the expected income, you should sell stocks higher than book value. If they are less, then they sell less than the book value. Book value is the amount of money all shareholders in a company would get if they were liquidated or sold for cash. It is the total amount value of assets minus the total cost of liabilities.
There are several methods businesses use to calculate estimated equity value. Equity value refers to the combination of loans and shares that a company can obtain because of its shareholders. This model uses one of them. It uses a formula that is a lot like the discounted cash flow (DCF) method with a few variations. The discounted cash flow (DCF) calculates its discount rate using a weighted average cost of capital (WACC). The Abnormal Earnings Valuation Model uses the torrent of residual earnings to calculate the company's discount rate.
BVPS, which stands for book value per common share, is a value used by investors to measure the "normal" rate of income returns predicted against. The Abnormal Earnings Valuation is the opposite of the values of BVPS. This does not necessarily make it a bad value, like when the predicted value of prospective earnings is progressive. It means that the business is creating value that is more than the book value—which is a good thing. Now, in a situation where the predicted value of prospective earnings is less than you expect, stock prices lower, or investors will be entitled to a discount on stock prices. Another similar model is EVA, the economic value-added model.
Example of the Abnormal Earnings Valuation Model
An AI and AR company have a book value per share of $20. This price can go up or drop with the slightest change in the company's financial performance. The market offers a value of $200, and the management team makes returns of $250. This is more than what the market is offering. The price of stocks will be more than $100.
If the management team made returns of $150, making it less than the market value, the stock price would be less than $20. And the company will blame the management team for not doing such a great job.
Significance of the Abnormal Earnings Valuation Model
The Abnormal Earnings Valuation Model predicts stock prices by using the company's book value and expected earnings. If the company stock share prices are more than the book value, it means the company's management team is doing a great job. If it falls below the book value, then the management team gets the blame.
The Abnormal Earnings Valuation Model determines a company's value and if it is a good investment. It also determines if the current price of stocks is fair or not, and the expertise of the management team is displayed. However, these values are on paper and not set in stone. There is always a chance that the model will fail miserably and perform poorly, thus hurting investors. The model takes changes like share buybacks etc., into consideration when recording book value.
If there is even the slightest error in calculations and assumptions, it can make the model useless. But the model risks for this model are quite high as there are several factors of the model like data programming and input errors or a misreading of the model's outputs that can make things quite messy.