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Definition: Abnormal Earnings Valuation Model
Abnormal Earnings Valuation Model is a way of evaluating the financial position of a company by considering revenues, income and book value of the company. This method gives a view of the company's performance to the investors, who can then consider their investments.
The company’s worth can be measured in terms of market determined price ‘or’ book value price. Market determined company’s worth is calculated by dividends or the share price of company.
For the investors, they can pay more than book value only if earnings are higher than anticipated and vice-versa. This also means that it will help investors to predict stock price of company.
Some of ratios to be compared for valuing company are
1) Price to earning ratio
2) return on capital employed
3) Discounted cash flow (DCF)
4) Price-to-book value ratio
5) ROE - return on equity
The performance of the company's top people is also judged through this evaluation method. Investors should caution them because No single number can give complete picture of company’s financial conditions. It is also known as residual income model.
Book value per share of Company ABC is $10
Now, if the company gives a higher return (above market expectations) the stock price will increase from 10 to infinity (hypothetical).
If the company returns less than expected, the company will bear the brunt since ABC would report lower-than-expected earnings per share.