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The Abnormal Earnings Growth Model: Applicability and Applications

Author

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  • Jennergren, L. Peter

    (Department of Accounting and Business Law)

  • Skogsvik, Kenth

    (Department of Accounting and Business Law)

Abstract

We investigate a disaggregated version of the abnormal earnings growth (AEG) model of Ohlson and Juettner-Nauroth (2005). The value of the firm then becomes discounted free cash flows minus initial debt. Discounted free cash flows are equal to capitalized operating earnings from the initial stock of operating assets plus the present value of an infinite sequence of growth projects, where each growth project is valued by discounted economic value added. Sufficient conditions for the present value of the free cash flows to be equal to the sum of these two components are investigated. The Gordon growth formula is found to be one special case. Another case concerns lumpy growth projects with depreciation according to the annuity method. We then allow for three different interest rates, the required rate of return on equity under all-equity financing, the borrowing rate, and the required rate of return on equity under partial debt financing (the latter given by MM's Proposition 2). In the model of Ohlson and Juettner-Nauroth, these rates are the same. A firm-level model is developed that focuses on operating earnings and free cash flows with discounting at the required rate of return under all-equity financing. An equity-level model is then developed that focuses on bottom-line earnings and dividends with discounting at the required rate of return under partial debt financing. Relationships between the two models are explored. Dividend policy irrelevance holds only in a limited sense for the equity-level model.

Suggested Citation

  • Jennergren, L. Peter & Skogsvik, Kenth, 2007. "The Abnormal Earnings Growth Model: Applicability and Applications," SSE/EFI Working Paper Series in Business Administration 2007:11, Stockholm School of Economics.
    • Handle: RePEc:hhb:hastba:2007_011
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    References listed on IDEAS

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    1. Ohlson, James & Gao, Zhan, 2006. "Earnings, Earnings Growth and Value," Foundations and Trends(R) in Accounting, now publishers, vol. 1(1), pages 1-70, August.
    2. Feltham, GA & Ohlson, JA, 1996. "Uncertainty resolution and the theory of depreciation measurement," Journal of Accounting Research, Wiley Blackwell, vol. 34(2), pages 209-234.
    3. Zhan Gao & James A. Ohlson & Adam J. Ostaszewski, 2013. "Dividend Policy Irrelevancy and the Construct of Earnings," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 40(5-6), pages 673-694, June.
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    1. Jennergren, L. Peter & Skogsvik, Kenth, 2008. "The Abnormal Earnings Growth Model, Two Exogenous Interest Rates, and Company Taxes," SSE/EFI Working Paper Series in Business Administration 2008:9, Stockholm School of Economics, revised 10 Mar 2009.

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    Keywords

    Financial analysis; abnormal earnings growth model; dividend policy; discounted dividends; discounted free cash flows; capitalized earnings; discounted economic value added;
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