Earnings are what matter in stock valuation. This is a conclusion arrived at by leading thinkers - even though different people have suggested different methods. Stephen Penman's approach in forwarding the Residual Income Method rests on two key arguments:
a. "Earnings that 'generate value' are what should be considered in stock valuation". [By contrast, dividends and free cash flow denote 'distribution of value' and hence, they are not the best measure for stock valuation. Hence he suggests that dividend discount model is not the most beneficial for valuation purposes.]
b. Dividends and free cash flow do not matter in company valuation. The stock market recognizes that earnings add value and dividends reduce value in the firm. What matters is residual earnings and abnormal earnings growth. Focusing on residual earnings and abnormal earnings growth is equivalent to anchoring valuations on book value or on capitalized earnings.
Important lessons from the Residual Income & Abnormal Earnings Method
{Edited excerpts from S. Penman}
The Residual Income + Abnormal Earnings Method does not target earnings per se, but rather residual earnings and abnormal earnings growth.
To illustrate what residual income essentially means, recall that the formula for residual income was RIt+1 = EPSt+1 – re * BVPSt. This can be rewritten as RIt+1 = (ROEt+1 – re)* BVPSt. Clearly, with this formula one can see that residual income is the income (loss) above (below) the cost of equity capital of a company. Thus, if a company earns more than its cost of equity capital, it generates abnormal earnings aka residual income.
Investors buy earnings but they must be careful in paying too much for earnings. Analysts trumpet earnings growth, but must be careful in overpricing earnings growth. Firms can deliver earnings growth that does not add value. The method protects the investor from paying too much for earnings.
Firms deliver earnings growth that does not add value in two ways. First, earnings can grow simply because of new investment, but investment does not necessarily add value. Think of serial acquirers like Tyco and WorldCom in the United States. These companies certainly grew earnings during the late 1990s, and so became darlings of Wall Street. But they did so largely by acquisitions of other firms. Acquisitions at fair value grow earnings, but they do not add value. Paying too much an acquisition (as empire builders do) destroys value, but can add earnings. An analyst who does not distinguish earnings that adds value from earnings that does not is in danger of paying too much for a share.
Second, earnings growth can be created by manipulating the accounting, and pure accounting does not add value. In the 1990s, many U.S. firms took large restructuring charges and other write-downs to assets. These charges reduce current earnings, of course, but result in higher future earnings: write-downs of inventories result in lower cost of good sold in subsequent years and fixed assets write-downs result in lower depreciation expense. All the more so if the firm overestimates there charges and so has to “bleed back” the charge to earnings in a later period. Some of the reported earnings in the U.S. were manufactured in this way, yet the stock market priced the earnings at high multiples.
Both valuation methods here protect the investor from buying earnings from investments that do not create value. The residual earnings model charges earnings from new investment with the required return on investment: new investment adds earnings but only adds value if it adds earnings in excess of the required return on the additional book value from the investment. The abnormal earnings growth model charges earnings growth for normal earnings growth: earnings growth only adds value if the growth is in excess of the required rate of growth.
The valuation attributes examined here – dividends, cash flows, earnings, and book values – yield the same valuation if they are forecasted for the very long run. But in the long run we are all dead. Valuations differ for finite horizon forecasts, and the issue is which attribute, forecasted over the short run, gives the best indication of value to be delivered in the long. I (Penman) suggest that dividends and free cash flows are not related to the value generation, so they do not inform about the long run. They are more concerned with the distribution of value. Earnings and book values, in contrast, are the result of an accounting that attempts to measure value added in a business
Notes:
Adapted from Stephen Penman's speech delivered in 2002 - "What Matters in Company Valuation:Earnings, Residual Earnings, Dividends?"
A comparison between the Abnormal Earnings Growth Model and the Residual Income Valuation Model
P.S: The main problem is that the RI model relies on the clean surplus relationship (CSR). This relationship means that all changes in equity, except dividends (dividends include issues and repurchases of shares), need to flow through the income statement first.
Studies have concluded that using the RIVM can yield higher returns, without taking more risk and that the RIVM is better than other models in predicting returns even for companies where book value may not reflect the expected market value.
Nevertheless, it is still possible that, since the RIVM needs the clean surplus relationship (CSR), the RIVM has greater valuation errors for firms that have dirty surplus items.
a. "Earnings that 'generate value' are what should be considered in stock valuation". [By contrast, dividends and free cash flow denote 'distribution of value' and hence, they are not the best measure for stock valuation. Hence he suggests that dividend discount model is not the most beneficial for valuation purposes.]
b. Dividends and free cash flow do not matter in company valuation. The stock market recognizes that earnings add value and dividends reduce value in the firm. What matters is residual earnings and abnormal earnings growth. Focusing on residual earnings and abnormal earnings growth is equivalent to anchoring valuations on book value or on capitalized earnings.
Important lessons from the Residual Income & Abnormal Earnings Method
{Edited excerpts from S. Penman}
The Residual Income + Abnormal Earnings Method does not target earnings per se, but rather residual earnings and abnormal earnings growth.
To illustrate what residual income essentially means, recall that the formula for residual income was RIt+1 = EPSt+1 – re * BVPSt. This can be rewritten as RIt+1 = (ROEt+1 – re)* BVPSt. Clearly, with this formula one can see that residual income is the income (loss) above (below) the cost of equity capital of a company. Thus, if a company earns more than its cost of equity capital, it generates abnormal earnings aka residual income.
Investors buy earnings but they must be careful in paying too much for earnings. Analysts trumpet earnings growth, but must be careful in overpricing earnings growth. Firms can deliver earnings growth that does not add value. The method protects the investor from paying too much for earnings.
Firms deliver earnings growth that does not add value in two ways. First, earnings can grow simply because of new investment, but investment does not necessarily add value. Think of serial acquirers like Tyco and WorldCom in the United States. These companies certainly grew earnings during the late 1990s, and so became darlings of Wall Street. But they did so largely by acquisitions of other firms. Acquisitions at fair value grow earnings, but they do not add value. Paying too much an acquisition (as empire builders do) destroys value, but can add earnings. An analyst who does not distinguish earnings that adds value from earnings that does not is in danger of paying too much for a share.
Second, earnings growth can be created by manipulating the accounting, and pure accounting does not add value. In the 1990s, many U.S. firms took large restructuring charges and other write-downs to assets. These charges reduce current earnings, of course, but result in higher future earnings: write-downs of inventories result in lower cost of good sold in subsequent years and fixed assets write-downs result in lower depreciation expense. All the more so if the firm overestimates there charges and so has to “bleed back” the charge to earnings in a later period. Some of the reported earnings in the U.S. were manufactured in this way, yet the stock market priced the earnings at high multiples.
Both valuation methods here protect the investor from buying earnings from investments that do not create value. The residual earnings model charges earnings from new investment with the required return on investment: new investment adds earnings but only adds value if it adds earnings in excess of the required return on the additional book value from the investment. The abnormal earnings growth model charges earnings growth for normal earnings growth: earnings growth only adds value if the growth is in excess of the required rate of growth.
The valuation attributes examined here – dividends, cash flows, earnings, and book values – yield the same valuation if they are forecasted for the very long run. But in the long run we are all dead. Valuations differ for finite horizon forecasts, and the issue is which attribute, forecasted over the short run, gives the best indication of value to be delivered in the long. I (Penman) suggest that dividends and free cash flows are not related to the value generation, so they do not inform about the long run. They are more concerned with the distribution of value. Earnings and book values, in contrast, are the result of an accounting that attempts to measure value added in a business
Notes:
Adapted from Stephen Penman's speech delivered in 2002 - "What Matters in Company Valuation:Earnings, Residual Earnings, Dividends?"
A comparison between the Abnormal Earnings Growth Model and the Residual Income Valuation Model
P.S: The main problem is that the RI model relies on the clean surplus relationship (CSR). This relationship means that all changes in equity, except dividends (dividends include issues and repurchases of shares), need to flow through the income statement first.
Studies have concluded that using the RIVM can yield higher returns, without taking more risk and that the RIVM is better than other models in predicting returns even for companies where book value may not reflect the expected market value.
Nevertheless, it is still possible that, since the RIVM needs the clean surplus relationship (CSR), the RIVM has greater valuation errors for firms that have dirty surplus items.
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