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Earnings Model Explanation

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.