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Josh Arnold
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I am an independent trader of options and stocks with about eight years of experience. I am an analyst in the banking space.
  • Earnings Model Explanation 10 comments
    Jul 24, 2013 5:44 PM

    This instablog's purpose is to explain in greater detail a model I use in my articles. I use a model that calculates economic value added based upon a company's asset base, earnings and necessary rate of return.

    The model uses inputs such as earnings growth rates, dividend rates, current book value, perpetual growth rate and the discount rate.

    This model is a different take on the DCF model for forecasting and discounting earnings. Basically, with the inputs described above, the model shows what the company's economic earnings (which are different from accounting earnings) are worth over the time period described. The company's ultimate value is based upon its ability to create shareholder value and to earn an economic profit based upon that shareholder value. The model's output shows us the value the company is creating above and beyond its economic cost of capital given the inputs.

    Basically, the way I think of the cost of capital for this model is by determining an acceptable annual rate of return. The cost of capital is a "tax" of sorts in the model wherein the cost of capital is multiplied by the company's book value to get the "normal" earnings you see below for each fiscal year. The "abnormal" portion of earnings is the amount of value the company is creating above and beyond its economic cost of capital, as described above. The idea, of course, is to have as much in the abnormal earnings row as possible as that implies the company is creating economic value with its asset base. These abnormal earnings are then discounted back to the present based upon the cost of capital rate used to derive a present value.

    If you have further questions regarding the model, its inputs or how it works, please feel free to contact me.

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Comments (10)
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  • bstet
    , contributor
    Comments (2) | Send Message
     
    Do you have a written equation that you solve for to get "abnormal earnings"?
    27 Aug 2014, 10:39 AM Reply Like
  • Josh Arnold
    , contributor
    Comments (2059) | Send Message
     
    Author’s reply » Abnormal earnings are just earnings over the cost of capital. Does that help?
    27 Aug 2014, 09:35 PM Reply Like
  • Shashi Kiran
    , contributor
    Comment (1) | Send Message
     
    A sample study, or a model using some simulated or real values that you explain this theory would be greatly appreciated.
    29 Aug 2014, 04:49 AM Reply Like
  • Ravi Dawar
    , contributor
    Comments (23) | Send Message
     
    I second Shashi's comments above. Would you be able to explain this method using a model?
    19 May 2015, 12:13 PM Reply Like
  • IseekAlphaToo
    , contributor
    Comments (13) | Send Message
     
    Can you please explain how you calculate future EOY Equity Book Values, ie your example for IBM? Its not very clear...

     

    Thanks
    17 Jun 2015, 04:07 PM Reply Like
  • IseekAlphaToo
    , contributor
    Comments (13) | Send Message
     
    Nevermind... Got it.
    17 Jun 2015, 04:16 PM Reply Like
  • Franco J
    , contributor
    Comments (2) | Send Message
     
    How did you calculate Value of Terminal Year and PV of terminal year AE? Numbers don't add up.
    28 Aug 2015, 11:57 AM Reply Like
  • Clay P
    , contributor
    Comment (1) | Send Message
     
    Yes, I am curious to know as well. I can't make the numbers work.
    10 Sep 2015, 12:29 PM Reply Like
  • Franco J
    , contributor
    Comments (2) | Send Message
     
    How is Value of Terminal year calculated and where does PV of all terminal year AE come from?
    28 Aug 2015, 11:57 AM Reply Like
  • Dan Mento
    , contributor
    Comment (1) | Send Message
     
    It seems that PV of terminal year AE is the year 6 abnormal earnings, divided by required return minus LT growth, discounted based on year 6 discount factor.

     

    What I'd like to ask is, why not add the the year 6 abnormal earnings to the Value of Terminal Year and discount all together, or, include the PV of year 6 abnormal earnings in the sum of discounted AE over horizon? Thanks.
    29 Sep 2015, 12:02 AM Reply Like
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