Contents - Index

Overview of the Abnormal Earnings Growth Valuation Model
©2009 OS Financial Trading System



The P/E ratio is a widely used number by the financial markets for relative valuation.  However, it is a number that can be easily manipulated by accounting changes.  The AEG model of valuation extends the ideas embraced in relative valuation and in particular the P/E ratio approach, to separate out growth in a P/E ratio that comes from accounting changes to real growth arising from the firm's investment decision after controlling for the firm's dividend decision.  
Two concepts are introduced for this purpose.  First, the effects of the dividend policy are undone with the concept of Cum-dividend earnings:
Cum-dividend earningst  = Earningst + (ke*Dividendt-1). 
In the above ke is the stock's cost of equity capital.  This concept undoes any pattern of dividends by accounting for them in terms of earning the firm's cost of equity capital so that when discounted by the firm's cost of equity capital this has zero intrinsic value implications.  However, it does provide the important benchmark for evaluating the firm's investment decision relative to the cost of equity capital.  
This second concept is Abnormal Earnings Growth.  This is defined as:
Abnormal earnings growth (AEG) = Cum-dividend earningst - Normal earningst 
                                                            = Earningst + (ke*Dividendt-1) - ke*Earningst-1                              1)
Since Normal earnings = ke * Earningst-1
Abnormal Growth Valuation Model 
Intrinsic Value = Capitalized earnings + Capitalized value from abnormal earnings growth
Intrinsic Valuet-1 = Earningst/ke + (PVt of future AEG for t+1, t+2, ….)/ke
There is a link between this model and Residual Income which follows from clean surplus accounting:
Re-arranging equation 1)
AEGt = Earningst - Earningst-1 - ke*(Earningst-1 - Dividendt-1)
Under clean surplus accounting dt-1 = Earningst-1 - (BVt - BVt-1), where Earningst-1 is comprehensive income for time period from t-1 to t, BVt-1 is book value per share at time t-1.
AEGt = Earningst - Earningst-1 - ke*(BVt - BVt-1)
It follows immediately that this can be re-arranged to express as the change in Residual Earnings.  Thisa will be later verified for IBM in this write-up.
AEGt = (Earningst  - ke*BVt)  - (Earningst-1 - ke*BVt-1) = REt - REt-1
Now you can recall that the AEG Valuation model capitalizes earnings and abnormal earnings:
AEG Intrinsic Value = Capitalized earnings + Capitalized value from abnormal earnings growth
Thus the valuation model can be re-expressed as:
AEG Intrinsic Valuet-1 = Earningst/ke + (PVt of Change in Residual Earnings for t+1, t+2, ….)/ke
In practice this model is often applied using regular accounting earnings and analyst earnings forecasts.