Introduction

Residual Earnings Valuation and Challenging Market Price

What are residual earnings?  Residual earnings are the return on book value in excess of the required return (the cost of equity capital). Residual earnings add value, but earnings at the required rate of return do not add value.  Fundamental to residual earnings valuation is that it is residual earnings growth and not earnings growth that adds value (see Warren Buffet’s “stopped clock” quote).

Importantly, speculative forecasts of future earnings per share and P/E ratios are not necessary for the model to forecast stock value. Given the current stock price, book value, Wall Street two year ahead earnings estimates, and the historic cost of equity capital of 10% (which can be changed), the interactive model calculates the growth rate of residual earnings embedded by the market in the current stock price and forecasts future stock values for seven years. Current stock value is decomposed and displayed by a graph of book value, value from near term accounting for earnings per share estimates, and value from long term speculative growth g.

Investor’s make several strategic mistakes buying stocks that Accounting For Value[1] Residual Earnings Method of stock valuation helps prevent. 

• The risk of investing in any stock is not beta, but the risk of paying too much for a stock.  Price is what you pay but value is what you get.
   
• Warren Buffet’s 1979 Letter to shareholders tells why investors often make the mistake of paying too much for growth:  “Earnings Per Share” will rise constantly on a dormant savings account or a US Savings Bond bearing a fixed rate of return simply because “earnings” (the stated interest rate) are continuously plowed back and added to the capital base.  Thus, even a stopped clock can look like a growth stock, if the dividend payout ratio is low.”
   
• Benjamin Graham and David Dodd, Securities Analysis, 1934, page 17, teaches: “We are concerned with the intrinsic value of the security and more particularly with the discovery of the discrepancies between intrinsic value and price…But it is a great mistake to imagine that intrinsic value is as definite and as determinable as the market price.” It is value “justified by the facts.” 
   
• The investor is not required to establish a valuation, but only to accept or reject the valuation of the market.

Stock valuation is actually a matter of accounting for value “justified by the facts.” Residual Earnings Method’s application of GAAP facilitates valuation and makes residual earnings stock valuation a powerful tool for the investor to challenge market price.  (See our interactive model value Cisco Systems Inc. for a demonstration.)