What is the Abnormal Earnings formula?

The Abnormal Earnings formula (also called Residual Income model) values a company as V0 = B0 + RI1/(1+r) + RI2/(1+r)^2 + ..., where B0 is book value, RI is residual income, and r is the cost of equity.

How is Residual Income (RI) calculated?

Residual Income (RI) is calculated as Net Income minus a charge for equity capital: RI = NIt − r × Bt−1, where NIt is net income, r is cost of equity, and Bt−1 is beginning book value.

What is the difference between Abnormal Earnings and Residual Income?

Abnormal Earnings and Residual Income are essentially the same concept—earnings above the required return on equity. Both terms are used interchangeably in financial valuation literature.

Why use the Abnormal Earnings model instead of DCF?

The Abnormal Earnings model captures value creation earlier than DCF by incorporating book value, making it particularly useful for financial firms and companies with significant tangible assets.

Residual Income Valuation Model

Abnormal Earnings Formula

Discover how to value companies using the Abnormal Earnings (Residual Income) model — a powerful alternative to DCF that captures value creation through economic profits.

V₀ = B₀ + RI₁/(1+r) + RI₂/(1+r)² + RI₃/(1+r)³ + …

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Understanding the Model

Four key components that make the Abnormal Earnings model a preferred choice for equity valuation.

B₀

Book Value

The starting point of valuation. Book value represents the equity capital already invested in the firm, providing a tangible anchor for the valuation process.

Residual Income

Earnings that exceed the required return on equity capital. Calculated as net income minus a charge for the cost of equity capital employed.

Cost of Equity

The minimum return required by equity investors. This discount rate reflects the riskiness of the firm's equity and is typically estimated using CAPM.

V₀

Intrinsic Value

The sum of current book value plus the present value of all future residual income streams, yielding the true intrinsic value of the firm's equity.

1890s

Origin of Residual Income concept

1995

Ohlson formalized the EBO model

90%+

Accuracy in firm valuation studies

3

Key input variables required

Frequently Asked Questions

Common questions about the Abnormal Earnings formula and its application.

The Abnormal Earnings formula (also known as the Residual Income model or Edwards-Bell-Ohlson model) states that a firm's equity value equals its current book value plus the present value of all expected future residual income. The formula is V₀ = B₀ + Σ RIₜ / (1+r)ᵗ, where RIₜ = NIₜ − r × Bₜ₋₁.

Residual Income is calculated as: RIₜ = Net Incomeₜ − (r × Book Valueₜ₋₁). If a company earns exactly its cost of equity, residual income is zero. Positive residual income indicates value creation, while negative residual income signals value destruction.

Abnormal Earnings and Residual Income refer to the same financial concept. Both measure the earnings generated above the required rate of return on equity capital. The terms are used interchangeably in academic literature and professional practice. The core idea is that a firm creates value only when it earns more than its cost of capital.

The Abnormal Earnings model offers several advantages over traditional DCF: it captures value creation earlier by anchoring on book value, it is less sensitive to terminal value assumptions, it works well for firms with significant tangible assets (like banks and insurance companies), and it aligns with accounting-based performance metrics used by many firms.