Excess return model

of Firm valuation

Presented by
KUNAAL (19397038)
G KIRITHIKA DEVI (19397036)
 “Excess returns are returns

WHAT IS EXCESS achieved above and beyond the return of a proxy.

RETURN ? Excess returns will depend on a designated

investment return comparison for analysis”

INTRODUCTION
 Excess returns are looking at the returns we can make
from our investments.

It is computed as the product of the excess return

made on an investment or investments and the capital
invested in that investment or investments.

We identify an excess return by subtracting one

investment’s return from the total percentage return we
achieve from another investment.
 Why it is useful for the firm?

 Some investors like to compare their excess returns to a risk-free rate; others may want to compare t
hem to comparable returns they might earn from another investment.
 The reasons for utilizing an excess return model are three: because banks, insurance companies, and
financial firms present special challenges for investors attempting to value these companies.
 CHALLENGES
The first challenge is that their businesses’ nature makes it difficult to define both debt and
reinvestment, making estimating cash flows far more difficult.
The second issue is that they tend to be heavily regulated, and changes in regulatory restrictions can
significantly impact the value.
The third challenge is the accounting rules that govern bank accounting have historically been very
different from accounting rules for other companies, with the assets being marked to market far more
frequently for financials.
BASICS TO EXCESS RETURN MODEL

A financial company that focuses its equity and earns its fair-
market rate of return on those investments will see its equity’s
market value converge on the equity capital invested that it has
invested.
Any bank that earns below fair-market value on its equity
investments will see its equity value fall below the equity capital
it is currently investing.
The excess return model also considers the future growth of that
equity and forecasts those reinvestments’ growth.
 SUPER PROFIT MODEL
Super profit is the excess of estimated future profit than
the normal profit. It is a way of determining the extra
profits that are earned by the business.

The goodwill is determined by multiplying the value of

super profits by a certain number (that number being the
number of years of purchase).
 EXAMPLE
The super profit method can be explained with the help of
the following question.
ABC Ltd has employed Rs.1000000 as the capital and the
investors are not very happy when the income obtained
from the investment is 30% while the actual profit obtained
is Rs. 4,00,000.
In this question, the normal profit is 30% of 1000000 which
is 3,00,000 and the actual profit is 4,00,000.
Therefore, the super profit is
Super Profit = Average estimated profit – Normal Profit
= 4,00,000 – 3,00,000
= 1,00,000
Abnormal Earnings Valuation
Abnormal profit is also known as supernormal profit
or excess profit.
 It defines about the net income or profit
gain over a product.
 “Any profit exceeding the normal profit”
 INTRODUCTION

The abnormal earnings valuation technique evaluates a company’s worth based on

two factors:

 The book value of the company and,

 its expected earnings
IMPORTANCE
The abnormal earnings valuation method
basically helps the investor to determine the
potential fair value of a stock.

“every stock is worth the company’s book

value if the investors just expect the
organization to earn a normal rate of return.”
 CALCULATION
 The discounting factor used should be the return required on equity rather than the weighted
average cost of capital.

Value of the Stock = Book Value + Perpetual Value of Future Expected Residual Incomes

 If the second half of the formula is positive, it means that the management is creating value by
delivering higher than expected returns for the shareholders.
 Key Concepts

 Any company’s potential earnings are generally influenced by the kind of resources (net assets) that

is available to management and the latter’s ability to generate a return (profitability) from such
assets.
 Any earnings that are higher than the expected return will be called positive abnormal earnings, and
any return less than expected return will be termed negative abnormal earnings.
 It is important to generate positive abnormal earnings from a long-term perspective in order to sell a
t a premium to the book value.
SOME OF THE POPULAR RATIOS THAT
ALSO NEED TO BE COMPARED ARE:

Price-to-earnings ratio
Price-to-book value ratio
Return on capital employed (ROCE)
Discounted cash flow (DCF)
Return on equity (ROE)
 EXAMPLE 1
The book value per share of ABC Inc. is $100. Suppose the company’s management is able

to generate a profit that is higher than the market’s expectation, then the price of the stock

will increase above $100 and thus will create more value for shareholders. On the other

hand, if the earnings are less than expected, the management will be responsible as the

wealth of the shareholders will be diluted.

 EXAMPLE 2
Apple, 2015 : Back in 2015, Apple managed to become the leading profit generating

company on the globe. With the profit of $53.4 billion and bank deposits of $216 billion.

With the increase in price, the fame of brand remained same and people still fall pray for its

overpriced products determine the success of the company.

 ADVANTAGES
Aligned with what market/analyst
forecast.
Incorporates the financial
Statements.
Shows quality of the management.
Focus on value drivers and
maximization of shareholders’
wealth.
 DISADVANTAGES
Accounting complexity can lead to
incorrect book value.
Not suitable for companies with a
consistent dividend policy.
Similar to DCF, it depends highly on
the forecast of business projections.
Forecast horizon can differ among
analysts, leading to incorrect judgment.
THANK YOU