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The concept of measuring a firm's anticipated wealth creation abilities has become the focus of much attention by both researchers and practitioners alike. Stern and Stewart (see Stewart [1991]), Edwards and Bell [1961], Ohlson [1995], and Frankel and Lee [1995] are among those who have addressed this issue. Many firms are adopting strategies made popular by the concept of economic value-added to align the interests of their employees with those of shareholders (see Tully [1993]).
Instead of using a dividend discount approach, these models measure value from the point of view of the firm's capacity for ongoing wealth creation rather than simply wealth distribution. While economic value-added pertains to both equity investors and debt holders, Edwards and Bell and Ohlson approach valuation from the perspective of the stockholder by focusing on residual income to equity investors only.
A primary objective of these models is to measure a firm's ability to generate abnormal earnings, that is, earnings in excess of its cost of capital for each period going forward. A firm's abnormal earnings for a given period t and cost of capital r can be stated as:
For example, a firm with a capital base of $100 million and an associated cost of capital of 10% that generates 12% in profits on capital is said to have $2 million in abnormal earnings. This is simply $12 million in net income minus the $10 million capital charge. The terms abnormal earnings and residual income are often used interchangeably, a practice followed in this article.
Residual income models compute an intrinsic value for each firm by combining its capital base, or book value, with the firm's cumulative present value of its anticipated future abnormal earnings. The firm's book value for each period is determined according to the clean surplus accounting relationship, which assumes that all changes in book value are determined by earnings and dividends (net of additional investments by owners in the firm). Thus, the derived book value in each period becomes the hurdle rate that the firm needs to overcome to generate positive abnormal earnings for the given period. By taking the ratio of each firm's intrinsic value to its market price within a given universe, we are able to generate percentile rankings for their securities.