9.1 Abnormal Earnings Growth Model

In Chapter 3, we introduced one of the most popular accounting ratios, the ROE (Return on Equity), and showed you how this ratio is related to growth (and is sometimes called “fundamental growth).     In the last chapter, you studied the RIV model, where the focus is on the book value of equity; in fact, we motivated the model in this way.  Most analysts, however, focus on earnings.  The P/E ratio is used as a valuation tool (the value equals expected earnings times the multiple).  The relationship between earnings and intrinsic value is the subject of much research, and some references include Williams (1938), Modiagliani and Miller (1958), Ohlson (1995) and Ohlson and   Juettner-Nauroth (2005).  The more recent works study the relationship between earnings and value under names like the Abnormal Earnings Growth model (AEG) and the “OJ” model.   In some ways, we have come full circle; we started with a cash-based model (the dividend model) and extended it to the free-cash flow model.  Then we moved to the RIV model and shifted the focus to the book value; we now return to earnings, which lie at the heart of cash flows and growth in shareholder equity.

The Abnormal Earnings Growth model carries along with it the clean surplus relationship and comprehensive earnings.  Under clean surplus, there is an implied equivalence relationship between AEG and the change in Residual Income, which this chapter demonstrates.  So you may ask: what is the contribution of AEG over and above the Residual Income model?  If they are analytically equivalent, then why not just apply the Residual Income model?  One answer to this question is that implementations of the two models can lead to multiple estimates of intrinsic value because real world imperfections imply that clean surplus will not literally hold.   A second is that the AEG model provides different insights into what drives firm value by focusing on earnings rather than book value.

The growth behavior of a firm in practice is complex and difficult to estimate.  In Chapter 1, we introduced the business model and business strategy, and you saw that growth behavior in the real world is both dynamic and complex.  In Chapter 3 we introduced the concepts of fundamental growth and the degree of leverage, the latter under a simple (fixed versus variable) cost behavior assumption.  These concepts provide methods for estimating growth directly from firm fundamentals.  In Chapter 3 and later, you saw that analysts provide discrete forecasts of growth behavior that you can access easily within Valuation Tutor.  These forecasts are for a specific set of times ahead, 1-quarter, 2-quarters, and 1-year, 2-year and 5-year forecasts.  However, imperfections in the market, such as information, measurement and aggregation imperfections, result in different approaches (analyst versus fundamentals) often providing very different growth estimates.  In fact, most growth estimates rely upon simplifying assumptions.  For these reasons the clean surplus relationships are unlikely to literally hold in the real world in the presence of dynamic and complex growth behavior, and the implementation of the two major accounting valuation models in practice will lead to different assessments of intrinsic value. 

When resolving these issues, equity analysts use their judgment combined with their knowledge of the business model, business strategy and how these affect financial statements.  For example, RIV often applies to firms whose business model requires significant assets on their books, such as a steel producer, while AEG best applies to business models that are best described from earnings, such as a talented human capital oriented firm.   Recall that shareholder equity is assets minus liabilities.  If a firm has mostly physical capital in its assets, ROE can be low.  On the other hand, a firm that generates the same earnings but has mostly human capital will have a very high ROE.  This is an imperfection in how assets are measured, and this makes a difference, as we now demonstrate.

Consider IBM.  Item 1A of their 10-K clearly identifies their strategic shift over the last decade:

Since they have exited commoditized segments to areas requiring less physical capital, earnings are more informative than the book value of assets in understanding IBM’s statements.  This comes up quite clearly when you compare estimates of fundamental growth for IBM based upon ROE versus current analyst forecasts.  To see this first select Fundamental Growth 2 Stage in the ROE form of the dividend model:

The Valuation Tutor calculator immediately flags the issue:

Fundamental growth when measured relative to the book value of shareholder’s equity (42.5%) is much higher than current five year analyst forecasts for IBM’s growth; the latter range between 10% and -11%.  This is to be expected given that IBM’s business model more heavily relies upon its human talent pool (which is not measured in a traditional balance sheet) compared to real assets that are measured by traditional accounting systems.  On the other hand, earnings reflects the results from its human talent pool.  This shift in business strategy also implies that IBM’s sensitivity to the business cycle has increased which analysts must consider when assessing the cost of equity capital. 

The specific learning objectives for this chapter are to understand:

·         What are Normal Earnings?

·         What are Cumulative-Dividend Earnings?

·         What is Abnormal Earnings Growth?

·         How do we estimate Abnormal Earnings Growth?

·         What are the major inputs into the Abnormal Earnings Growth Model?

·         How do we apply the Abnormal Earnings Growth Model Using Valuation Tutor?

·         How to perform sensitivity analysis on the key drivers to test their reasonableness?

·         What is the expected return from a stock using the AEG model?

In the first section we will first develop the new concepts introduced before applying the AEG Model.  We start by defining what is meant by Normal Earnings and then relate this concept to the idea of Abnormal Earnings Growth. 

As in the residual income model, the accounting concept of income is extended to account for opportunity costs.  In the last chapter we focused upon the balance sheet to calculate opportunity costs in terms of the cost of equity capital times the book value of shareholders’ equity net of dividends paid to shareholders.  In this chapter we focus on the income statement and calculate opportunity costs directly with respect to comprehensive income (cum-dividends) and then adjust for the opportunity costs associated with dividends paid to shareholders  Under clean surplus accounting and in a perfect market world these two approaches are equivalent.  However, in a world with market imperfections arising from aggregation issues, incomplete information and problems associated with forecasting dynamic growth behavior these two approaches will differ when implemented. As a result, judgment must be used when choosing which valuation technique to apply and this will depend upon assessing which statement is more affected by these market imperfections as suggested by the IBM example provided in the introduction.