Abnormal Earnings Growth

The Concept Behind the P/E Ratio

• Price in numerator of P/E is based on expected future earnings
• Earnings in denominator is current (or forward) earnings
• P/E is thus based on expected growth in earnings
• Compare with price-to-book:
P/B is based on expected earnings relative to current book value (ROCE)
ROCE is growth in book value
P/B is based on expected growth in book value
 Beware of Paying Too Much for
Earnings Growth

• Investment creates growth but does not necessarily add

value
• Earnings growth can be created by the accounting
We need a valuation method that protects us from paying
too much for earnings growth
Reminder: Residual Earnings Valuation Protects You
From Paying Too Much For Earnings
• Earnings from new investment is charged with the required return on
investment
Residual earnings before new investment: 10% hurdle rate

RE = 12 – (0.10 x 100) = 2 (ROCE = 12%)

Residual earnings after new investment of $20 million earning at 10%

RE = 14 – (0.10 x 120) = 2

No value added from new investment

Creating earnings by accounting methods also increases residual earnings but
reduces book value. The net effect is zero. See Chapter 5.
A P/E model must also protect you from paying too much for earnings
growth.
 The Prototype Savings Account
2000 2001 2002 2003 2004 2005

Earnings withdrawn each year (full payout)

Earnings 5 5 5 5 5
Dividends 5 5 5 5 5
Book value 100 100 100 100 100 100

Residual earnings 0 0 0 0 0

Earnings growth rate 0 0 0 0 0

Cum-dividend earnings 5 5.25 5.51 5.79 6.08
Cum-dividend earnings growth rate 5% 5% 5% 5%

No withdrawals (zero payout)

Earnings 5 5.25 5.51 5.79 6.08

Dividends 0 0 0 0 0
Book value 100 105 110.25 115.76 121.55 127.63

Residual earnings 0 0 0 0 0

Earnings growth rate 5% 5% 5% 5%

Cum-dividend earnings 5 5.25 5.51 5.79 6.08
Cum-dividend earnings growth rate 5% 5% 5% 5%

forward earnings 5 1 1
Value of savings account    100 Forward P/E    20
required return 0.05 required return 0.05
 The Trailing P/E and Forward P/E
Price0
Forward P/E 
Earnings1

Price0  Dividend0
Trailing P/E 
Earnings0

[Dividends reduce current price, but not current earnings]

1
Normal Forward P/E 
required return

1  required return
Normal Trailing P/E 
required return

Normal Forward P/E  Normal Trailing P/E  1

 Cum-Dividend Earnings
For the zero-payout account:
2001 2002 2003 2004 2005
Cum-dividend earnings 5.00 5.25 5.51 5.79 6.08

For the full-payout account:

Earnings in the account 5.00 5.00 5.00 5.00 5.00

Dividend reinvested @ 5% 0.25 0.51 0.79 1.08
Cum-dividend earnings 5.00 5.25 5.51 5.79 6.08

Cum-dividend earnings (2002) 

Earnings (2002)   0.05  Dividend (2001) 

The two accounts have different (ex-dividend) earnings growth, but the same
cum-dividend earnings growth
 Normal Earnings

Normal Earnings is earnings growing at the required rate of return:

Normal Earnings   E Earnings t 1

For the savings account:

Normal Earnings (2002)  1.05  Earnings (2001)
= 1.05 x 5.00= 5.25

Normal Earnings (2003)  1.05  5.25

= 5.5125
 Abnormal Earnings Growth (AEG)

Abnormal Earnings Growth is growth over normal

earnings growth

AEG = Cum-dividend earnings – Normal earnings

For the Savings account:

AEG  2002  5.25  5.25  0
AEG  2003  5.5125  5.5125  0
 Lessons from the Savings Account

1. An asset is worth capitalized forward earnings if abnormal

earnings growth is expected to be zero.

2. An asset has a normal P/E ratio if abnormal earnings

growth is expected to be zero.

3. Earnings comes from two sources:

 earnings from the asset
 earnings from reinvesting dividends

4. Dividends do not affect cum-dividend earnings

5. Dividend payout does not affect value.

 A Bad P/E Model

Earn1
Value 
-g
Does not work for a savings account!

  g  1.05
 A Model of the Forward P/E
Value of savings account =
Capitalized forward earnings + No extra value

• Extra value is added if abnormal earnings growth is forecasted

The model:
Value of equity = Capitalized forward earnings + Extra value for
abnormal
earnings growth

Earn1 1  AEG2 AEG3 AEG4 

V E
     
 E  1  E  1   E
0
 E2  E3 

1  AEG2 AEG3 AEG4 

 Earn    
 E  1  
1 
E  E2  E3 

 V0E 
 
The intrinsic P/E  Earn  is given by dividing through by Earn1
 1 
Measuring Abnormal Earnings Growth for Equities

Abnormal earnings growtht (AEGt) = Cum-dividend earnt - Normal earnt

= [Earnt + (ρE – 1) dt-1] – ρ Earnt-1

PQR Ltd.: Required return = 11% Eps 2004 = 1.03

Liberty Ltd. Required return = 10% Eps 2004 = 3.59

PQR Ltd. Liberty Ltd.
1.18 4.45
Eps 2005 0.00 0.74
Dps 2004 0.00 0.074
Earnings on reinvested dividends 1.18 4.524
Cum-dividend earnings 2005
Normal earnings from 2004:
PQR: 1.03 x 1.11; Liberty: 3.59 x 1.10 1.143 3.949
Abnormal earnings growth (AEG) 2005 0.037 0.575
 Cum-dividend Earnings Growth Rate

Cum-dividend earnings
growth rate (plus one):

Cum  dividend earningst

Gt 
Earningst 1

Cum  divided earningst

Note: This is not Cum  dividend earningst 1
 Alternative Calculation of AEG

Abnormal earnings growtht = [Gt – ρE] x Earningst-1

Where

Gt = Cum-dividend earnings growth rate (plus one)

For Liberty:

G2005 = 4.524/3.59 = 1.2602% (a 26.02% growth rate)

AEG2005= [1.2602 – 1.10] x 3.59 = 0.575

Applying the Model
• Forecast one-year-ahead earnings.
• Add the present of value (at the end of the year 1) of
expected abnormal earnings growth for year two ahead
and onwards
• Capitalized the total of forward earnings and the value
of abnormal earnings growth.
Applying the Model

Forecasts
Year 1 ahead Year 2 ahead Year 3 ahead Year 4 ahead

Cum Normal Cum Normal Cum Normal

Forward dividend earnings2 dividend earnings2 dividend earnings4
Earnings1 earnings2 earnings3 earnings4

Abnormal Earnings2 Abnormal Earnings3 Abnormal Earnings4

+
PV of
Discount by 
AEG2

+
PV of
Discount by 2
AEG3
+
PV of
Discount by 3
AEG4

+
-
-
+
Current
Total
Value Capitalize earnings
plus growth
Forward P/E Ratios and Subsequent Earnings Growth
Rates: S&P 500 Firms

Earnings Grow th Rate on Forw ard P/E Ratio

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0
0 4 8 12 16 20 24 28 32 36 40
F o rwa rd P /E R a tio (2000)
 Applying the Model: A Simple Example
Forecast for a firm with expected earnings growth of 3 percent per year. Required return is 10% per year.

2000 2001 2002 2003 2004 2005

Earnings 12.00 12.36 12.73 13.11 13.51 13.91

Dividends 9.09 9.36 9.64 9.93 10.23 10.53

Book value 100.00 103.00 106.09 109.27 112.55 115.93

RE (0.10) 2.36 2.43 2.50 2.58 2.66

RE growth rate 3% 3% 3% 3%

Earnings on reinvested dividends 0.936 0.964 0.993 1.023

Cum-dividend earnings 13.667 14.077 14.499 14.934

Normal earnings 13.596 14.004 14.424 14.857

Abnormal earnings growth 0.071 0.073 0.075 0.077

Earnings growth rate 3% 3% 3% 3%

Cum-dividend 10.6% 10.6% 10.6% 10.6%

earnings growth rate

Abnormal earnings growth rate 3% 3% 3%

Residual earnings valuation: AEG valuation:

2.36 1  0.071 
E
V2000  100   133.71 E
V2000  12.36   133.71
1.10  1.03 0.10  1.10  1.03 
 A Case 1 Valuation: XYZ Ltd.
Required return is 10%
In this case, abnormal earnings growth is expected to be zero after 2004

Forecast Year

1999 2000 2001 2002 2003 2004

Dps 0.57 0.66 0.73 0.77 0.82

Eps 1.29 1.38 1.42 1.50 1.60
Dps reinvested at 10% 0.057 0.066 0.073 0.077
Cum-dividend earnings
(eps + dps reinvested) 1.437 1.486 1.573 1.677
Normal earnings (1.10 x epst-1) 1.419 1.518 1.562 1.650
Abnormal earnings growth (AEG) 0.018 -0.032 0.011 0.027
Discount rate (1.10t) 1.100 1.210 1.331 1.464
PV of AEG 0.016 -0.026 0.008 0.028
Total PV of AEG 0.017
Total earnings to be capitalized 1.307
Capitalization rate 0.10

 1.307 
Value per share   13.07
 0.10 

1
E
V1999  1.29  0.017  13.07
0.10
Same as residual earnings valuation
 A Case 2 Valuation: PQR Ltd.
Required return is 11%
In this case, abnormal earnings growth is expected to grow at a 6.5 percent rate after 2006

Forecast Year

2000 2001 2002 2003 2004 2005 2006

Dps 0.0 0.0 0.0 0.0 0.0 0.0
Eps 0.84 0.48 0.82 1.03 1.18 1.35
Dps reinvested (0.11 × dpst-1) 0.00 0.00 0.00 0.00 0.00
Cum-dividend earnings 0.48 0.82 1.03 1.18 1.349
Normal earnings (1.11 × epst-1) 0.932 0.533 0.910 1.143 1.310
Abnormal earnings growth -0.452 0.287 0.120 0.037 0.039
Discount rate (1.11t) 1.110 1.232 1.368 1.518
Present value of AEG -0.408 0.233 0.088 0.025
Total PV of AEG -0.062
Continuing value (CV) 0.873
PV of CV 0.576
Total earnings to be capitalized 1.354
Capitalization rate 0.11

Value per share 12.31

 1.354 
 
The continuing value calculation:
 0.11 

CV = = 0.873
0.0393
Present value
1.11 of1.CV
065= = 0.576
0.873
1.5181
1
E
V2000   0.84  0.062  0.576  12.31
0.11
Same as residual earnings valuation
 Converting Analysts’ Forecasts to a Valuation: Action Ltd.

Price = 41 Required return = 10%

Consensus eps forecasts:
2005 3.43
2006 3.81
5-year growth rate = 14%

2004 2005E 2006E 2007E 2008E 2009E

Dps 0.30 0.33 0.38 0.43 0.49

Eps 3.43 3.81 4.43 4.95 5.65
Dps reinvested (0.10 x dpst-1) 0.030 0.033 0.038 0.043
Cum-dividend earnings 3.840 4.373 4.988 5.693
Normal earnings (1.10 x epst-1) 3.773 4.191 4.774 5.445
Abnormal earnings growth 0.067 0.182 0.214 0.248
Cum-div eps growth rate 11.95% 14.78% 14.93% 15.00%
Discount rate (1.10t) 1.100 1.210 1.331 1.464
Present value of AEG 0.061 0.150 0.161 0.169
Total PV of AEG 0.54
Continuing value (CV) 4.299
PV of CV 2.94
Total earnings to be capitalized 6.91
Capitalization rate 0.10
 6.91 
Value per share  
 0.10  69.10

The continuing value calculation:

0.248 x 1.04 4.299
CV   4.299  2.94
1.10  1.04 1.4641
Present value of CV =
 Abnormal Earnings Growth is Equal to the
Change in Residual Earnings
AEG t = [earn t + (ρ E – 1)d t-1 ] - ρ E earn t-1
 earn t  earn t 1  (ρ E  1)[earn t 1  d t 1 ]

By the stocks and flows equation for accounting for the book value of equity

B t-1 = B t-2 + earn t-1 – dt-1 , so earn t-1 – d t-1 = B t-1 – B t-2 . Thus,

AEG t = earn t – earn t-1 - (ρ E – 1)[Bt-1 – B t-2 ]

= [earn t - (ρ E – 1)B t-1 ] - [ earn t-1 - (ρ E – 1)B t-2 ]

= RE t – RE t-1

So, the AEG model can be written as:

1  RE2 RE3 RE4 

V0E  Earn     ....
 E  1  
1
E  E2  E3 
 Forecasting Changes in Residual Earnings
Calculation of equity value using the abnormal earnings growth model. Abnormal earnings growth is
the difference between residual earnings in two subsequent periods.

Forecasts
Year 1 ahead Year 2 ahead Year 3 ahead Year 4 ahead
Residual Residual Residual Residual Residual Residual
Forward income2 income1 income3 income2 income4 income3
Earnings1

Abnormal Earnings2 Abnormal Earnings3 Abnormal Earnings4

+
PV of
Discount by 
AEG2
+
PV of
Discount by 2
AEG3
+
PV of
Discount by 3
AEG4
+
-
-
+
Current
Total
Value Capitaliz earnings
e plus growth
Protection From Earnings Created by Accounting:
A Restructuring Charge
2000 2001 2002 2003 2004 2005

Earnings 4.00 20.36 12.73 13.11 13.51 13.91

Dividends 9.09 9.36 9.64 9.93 10.23 10.54

Book value 92.00 103.00 106.09 109.27 112.55 115.93

Earnings on reinvested
dividends 0.936 0.964 0.993 1.023

Cum-dividend earnings 13.667 14.077 14.499 14.934

Normal earnings 22.396 14.004 14.424 14.857

Abnormal earnings growth (8.729) 0.073 0.075 0.077

Abnormal earnings growth rate 3% 3% 3%

1  8.729 0.073 
E
V2000  20.36   1 .10   133.71
0.10  1.10 1.10  1.03 
 Abnormal Earnings Growth Analysis:
Advantages and Disadvantages
Advantages Disadvantages
• Easy to understand: Investors think • Accounting complexity: Requires an understanding of how accrual
in terms of future earnings; investors accounting works.
buy earnings. Focuses directly on the • Concept complexity: Requires an appreciation of the concept of cum-
most common multiple used, the P/E dividend earnings; that is, value is based on earnings to be earned within the
ratio. firm and from earnings from the reinvestment of dividends.
• Uses accrual accounting: Embeds • Application to strategy: Does not give an insight into the drivers of earnings
the properties of accrual accounting
by which revenues are matched with growth, particularly balance sheet items, so is not suited to strategy analysis.
expenses to measure value added • Suspect accounting: Relies on earnings numbers that can be suspect
from selling products. • Forecast horizon: Forecast horizons can be shorter than those for DCF
• Versatility: Can be used under a analysis and more value is typically recognized in the immediate future. But
variety of accounting principles the forecast horizon does depend on the quality of the accrual accounting
• Aligned with what people forecast:
Analysts forecast earnings and
earnings growth.
 Reverse Engineering: S&P 500
S&P 500, January 2004: 1000

Earnings forecasts:
2004 53.00
Forward P/E = 18.87
2005 58.20

S&P 500 payout ratio = 31%

Required return = 4% + 5% = 9%

2004 2005

Earnings 53.00 58.20

Dividends (31% payout) 16.43
Reinvested dividends at 9% 1.479
Cum-dividend earnings 59.679
Normal earnings ($53 x 1.09) 57.770
AEG 1.909

With these ingredients, we are ready to reverse engineer:

1  1.909 
E
V2003  1000  53.00 
g = 1.039 (a 3.9% growth rate)
0.09  1.09 - g  Compare with GDP growth rate
 Reverse Engineering Growth Forecasts: Reebok

Price = 41
2004 2005E 2006E

Dps 0.30 0.33

Eps 3.43 3.81
Dps reinvested (0.10 x dpst-1) 0.030
Cum-dividend earnings 3.840
Normal earnings (1.10 x epst-1) 3.773
Abnormal earnings growth 0.067

1  0.067 
E
V2004  41  3.43 
0.10  1.10 - g 

g = 1.0 (no growth expected)

Analysts were forecasting growth!

 Reverse Engineering Expected Returns: The
Simple Example
Market Price = 147.2 million

1  AEG2 
E
V2004  147.2 million  12.36 
  1    1.03 

Set AEG2   12.73     1  9.36      12.36

p  1.0935 (a 9.35% expected return)

The formula is:

Earn1  Earn2  Earn1 

p  1 A  A2  x    g  1 
P0  Earn1 
1 dps1 
where A   g  1  
A bit ugly, but is 2works!
 P0 
 Implied Earnings Forecasts

Earnings Forecast = Normal earnings forecast + AEG forecast

- Forecast of earnings from prior year’s dividends

Reebok:

Normal earnings2007 = 4.191

AEG2007 = 0.067 (no growth from 2006)

Reinvested dividends for 2007 = 0.033

Market implied eps forecast for 2007:

= 4.191 + 0.067 – 0.033

= 4.225

Implied eps growth rate for 2007 = 4.225/3.81 = 10.89%

 The Market’s Eps Growth Path: Action

11.50%

11.25%
11.08%
11.00%
10.89% BUY
10.75% 10.72%
10.56%
10.50%
SELL 10.42%
10.30%
10.25%
10.19%

10.00%

9.75%
2006 2007 2008 2009 2010 2011 2012
 Building Blocks of an AEG Valuation: Action
V alue P er S hare

Current Market Value

41.00
6.70
34.3

Captalized
Forward
Earnings

(1) (2) (3)

Value from Value from Value from
forward short-term long-term
earnings forecasts forecasts

(1) Value from capitalized forward earnings, about which one is reasonably certain
(2) Value from capitalizing two-year-ahead abnormal earnings growth
(3) Value from forecasts of long-term growth, the most speculative part of the valuation.
 The “Greenspan” Model
• If Earnings Yield is less than 10-year treasury note yield,
stocks are overpriced
Forward earnings 1
Earnings yield  
Price Forward P/E

• In 1998: “irrational exuberance” speech

Treasury yield = 5.60% (P/E = 17.86)
Earnings yield = 4.75% (P/E = 21.05)

• A good model?

 Different risk for bonds and stocks

 P/E should be higher for bonds (and earnings yields lower)

 Stocks deliver AEG, bonds do not

 P/E can be higher for stocks (and earnings yields lower)
 P/E Ratios and Interest Rates: 1963 – 2003
Median P/E ratios and interest rates (in percentages) on one-year Treasury bills

20 interest rate P/E ratio

18

16

14

12

10

0
 The PEG Ratio

PEG RATIO = P/E

1-year ahead percentage earnings growth

Does it work as a screen?