Abnormal Earnings Valuation Model Definition with Example
Abnormal Earnings Valuation Model Definition – “A model that evaluates worth of a company with respect to its book value and earnings”
This model is used to assess the managers decision regarding his or her anticipation about profit and loss. On the basis of managers earnings anticipation, investors make their decisions. If the earnings are higher than the anticipated earnings, then investors pay higher value of the stock comparatively to its book value. Similarly if the earnings are less than the anticipated one, investors gives less amount than the book value.
In short and simple words, this model is very helpful for the investors to decide the true price of the stock that they are buying. Ratios that are pertinent in valuating the company are given below –
- Returns on Capital Employed
- Discounted Cash Flow
- Price to book value ratio
- Return on Equity
- Price to earning ratio
Related Financial Terms of Accounting Standards
- Accounting Definition – Meaning and Importance
- Gross Profit Definition – Meaning, Example and Importance
Abnormal Earnings Valuation Model Example
In order to understand abnormal earnings valuation model definition more clearly, let’s discuss a simple example –
Let’s assume the book value per share of XYZ is Rs 50. However any change in the financial performance can fluctuate this price. Suppose managers are able to earn profit more than the market is providing, then the investors credit them as well the price of stock will also increase. On the other hand, if the earnings are less, the management has to take the blame for the same. In addition to this, the stock price will also decrease.
Abnormal Earnings Valuation Model Importance
The most important use of this model is that it helps in valuing the worth of a company. This helps the investors to carefully made their decision before investing in any organisation. In addition to this, it also helps in setting a true and fair price of the stock. Moreover it also reflects the management’s ability to take right decisions.