Abnormal Earnings Method – Not Entirely Useless

When we were introduced to the Abnormal Earnings method in Business Analysis and Valuation, I was decomposing the math formula which constructs the value of the equity. As far as I was concerned, it didn’t really tell us anything we didn’t already know through a equity based discounted cash flow (FCFE discounted at re).

However, there was an interesting scenario in which this method actually told us something unique. First the formula:

Market Value = Book Value + (NI1 – re*BV)/re + (NI2 – re*BV)/re^2 + …

Nix is Net Income in year x

BV is book value

While in theory, this formula should return a similar value to an equity based DCF, one unique value is that the valuation is relative to book value, rather than strictly looking at only cash flows. Essentially, what it is saying is, the company is worth it’s book value, PLUS it’s “abnormal earnings” where abnormal earnings are the earnings you get in excess of what you would expect (re).

So in looking at a company that is trading below book value, I used to think that it meant that the market did not believe in the company’s management to perform (the company was burning cash). But it doesn’t just have to be that the company is on a “crash” course. It could also just be that the company is not performing as “expected” that is to say there net income is not necessarily negative, but simply less than what is expected.