Define Abnormal Earnings Valuation Model:

"The abnormal earnings valuation model, also known as the Residual Income Model (RIM), is a financial valuation approach used to estimate the intrinsic value of a company's common stock."

Explain Abnormal Earnings Valuation Model:

The abnormal earnings valuation model, also known as the Residual Income Model (RIM), is a financial valuation approach used to estimate the intrinsic value of a company's common stock. It is a variation of the discounted cash flow (DCF) method and relies on the concept of economic profit or residual income.

The core idea behind the abnormal earnings valuation model is that a company's stock price is influenced not only by its reported accounting earnings but also by its ability to generate economic profit beyond what is expected by investors. Economic profit is the difference between a company's actual earnings and its equity charge (the required return on shareholders' equity).

The formula for calculating abnormal earnings in a given period is as follows:

Abnormal Earnings (AE) = Actual Earnings - Equity Charge

Where:

• Actual Earnings: The net income or accounting earnings reported by the company for the period.
• Equity Charge: The required return on shareholders' equity, which is calculated based on the company's cost of equity and its shareholders' equity.

To apply the abnormal earnings valuation model, the following steps are typically taken:

1. Calculate the equity charge based on the cost of equity and shareholders' equity.
2. Estimate the company's future accounting earnings (forecast period).
3. Determine the abnormal earnings for each forecast period using the formula mentioned above.
4. Discount the estimated abnormal earnings back to the present value using an appropriate discount rate (cost of equity or required rate of return).
5. Sum the present value of abnormal earnings with the present value of dividends or the terminal value (if using a two-stage model) to derive the intrinsic value of the company's common stock.

The abnormal earnings valuation model considers the company's ability to generate economic profits above the cost of equity, which captures the shareholders' required return on their investment. It is particularly useful for valuing companies that are expected to have sustainable competitive advantages or earn returns above the cost of capital in the long run. However, like any valuation model, it relies on various assumptions and forecasts, and the results are sensitive to changes in these inputs.

Let's illustrate the abnormal earnings valuation model with a simplified numerical example:

Suppose we have a company called XYZ Inc., and we want to estimate the intrinsic value of its common stock using the abnormal earnings valuation model. Here are the relevant data for the example:

1. Cost of Equity (Required Rate of Return): 10%
2. Shareholders' Equity: $1,000,000
3. Forecasted Accounting Earnings for Year 1: $150,000
4. Forecasted Accounting Earnings for Year 2: $180,000

Steps to calculate the intrinsic value using the abnormal earnings valuation model:

Step 1: Calculate the Equity Charge (required return on shareholders' equity):

Equity Charge = Cost of Equity × Shareholders' Equity Equity Charge = 0.10 × $1,000,000 Equity Charge = $100,000

Step 2: Calculate Abnormal Earnings for each forecast period:

Abnormal Earnings (Year 1) = Actual Earnings (Year 1) - Equity Charge Abnormal Earnings (Year 1) = $150,000 - $100,000 Abnormal Earnings (Year 1) = $50,000

Abnormal Earnings (Year 2) = Actual Earnings (Year 2) - Equity Charge Abnormal Earnings (Year 2) = $180,000 - $100,000 Abnormal Earnings (Year 2) = $80,000

Step 3: Discount Abnormal Earnings back to the present value using the cost of equity (required rate of return):

Present Value of Abnormal Earnings (Year 1) = $50,000 / (1 + 0.10)¹ Present Value of Abnormal Earnings (Year 1) = $45,454.55

Present Value of Abnormal Earnings (Year 2) = $80,000 / (1 + 0.10)² Present Value of Abnormal Earnings (Year 2) = $66,115.70

Step 4: Calculate the Intrinsic Value of the Common Stock:

Intrinsic Value = Present Value of Abnormal Earnings (Year 1) + Present Value of Abnormal Earnings (Year 2) Intrinsic Value = $45,454.55 + $66,115.70 Intrinsic Value = $111,570.25

The estimated intrinsic value of XYZ Inc.'s common stock using the abnormal earnings valuation model is $111,570.25.

Please note that this is a simplified example for illustrative purposes, and in practice, the valuation process may involve more complex calculations and considerations of additional factors and forecast periods.