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The Abnormal Earnings Growth Model: Applicability and Applications

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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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    File URL: http://swoba.hhs.se/hastba/papers/hastba2007_011.pdf
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    References listed on IDEAS

    as
    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. repec:bla:joares:v:34:y:1996:i:2:p:209-234 is not listed on IDEAS
    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.
    Full references (including those not matched with items on IDEAS)

    More about this item

    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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