Abnormal Earnings Growth Research Articles

Comparison of the Residual Income Valuation, Abnormal Earnings Growth and Free Cash Flow Models: An empirical study of the Brazilian capital market

This study compares the explanatory power of the residual income valuation (RIV), abnormal earnings growth (AEG) and free cash flow (FCF) models in the Brazilian capital market, through an empirical test to compare the three models, using data on companies listed on the BOVESPA. Each model was analyzed annually over the period from 1995 to 2002 by multiple linear regression. The results show that from 1995 to 1999 the RIV model had better explanatory power than the other two models, and from 2000 to 2002 the AEG and RIV models were the same, an indicator of the Brazilian market’s development in the more recent years of the study period. The FCF model had the least explanatory power in all the years analyzed. The results were confirmed by panel data analysis.

Accounting Valuation Models: A Short Primer

This note discusses basic issues related to residual income valuation (RIV) and abnormal earnings growth (AEG) models but has only scratched the surface of a complex subject. What clearly emerges from this ‘primer’ is the conclusion that AEG is a more complex valuation model than RIV. This complexity concerns both the mechanics and interpretation of AEG compared to RIV. Furthermore, a study by Penman (2005) raises a question about the usefulness of AEG compared to RIV. His comparisons between RIV and AEG are rather remarkable and suggest that RIV gives estimates of value which are more accurate and less variable than estimates based on AEG. Clearly, these results need further study.

Error in Constant Growth Accounting Valuation Models

The fundamental assumption of accounting-based valuation models is that in the long-run, the accounting component vanishes and dividends are recovered. Therefore, accounting policies do not matter. In the extensive literature on the subject, this assumption has not been questioned. The key proposition of this paper is that when these models are parameterized and constant growth is assumed, accounting policies do matter and impact the valuation. The valuation error is due to the non vanishing terminal value in the model. Thus, the characteristics of the accounting system that are implied by the assumption of constant growth violate the core assumption of both the residual income valuation model and the abnormal earnings growth model. There is one exception. When constant payout is assumed, the terminal value disappears.

On Accounting-Based Valuation Formulae*

This paper considers accounting-based valuation formulae. Its initial focus is on two problems related to residual income valuation (RIV). First, insofar valuation depends on theresent value of expected dividends per share, applying RIV requires clean surplus accounting on a per share basis. Awkwardly, equity transactions that change the number of shares outstanding generally imply eps ≠ Δ bvps − dps. A clean surplus equality holds only if one “re-conceptualizes” either end-of-period bvps or eps as a forced “plug”. Second, one cannot circumvent the per share issue by evaluating RIV on a total dollar value basis unless one introduces relatively subtle MM-type restrictions. In light of RIV’s unsatisfactory aspects, the paper proposes an alternative to RIV. This new approach maintains a strict eps-focus. It derives by replacing bvps t in RIV with eps t +1 capitalized (i.e. divided by r). One obtains a formula such that the current market price equals next-period expected earnings capitalized plus the present value of expected abnormal earnings growth, referred to as AEG. A number of propositions then demonstrate the advantages of the AEG approach as compared to RIV. These results follow because eps t+1 capitalized generally approximates market price better than bvps t .

Discussion of “On Accounting-Based Valuation Formulae” and “Expected EPS and EPS Growthas Determinants of Value”

This discussion evaluates the abnormal earnings growth valuation (AEG) Model of Ohlson and Juettner-Nauroth and, in similar vein to the Ohlson review paper at this conference, compares the Model to the residual income valuation (RIV) Model that has been the centerpiece of accounting-based valuation in recent years. The discussion begins with a statement of what one looks for in a practical valuation model. The innovations of the AEG Model, well stated by Ohlson, are acknowledged. A comparison of the advantages and disadvantages of the alternative approaches provides some qualification, however, and draws out the utility of a residual income valuation approach.