The clean surplus accounting method provides elements of a forecasting model that yields price as a function of earnings, expected returns, and change in
book value.
[Ohlson, J. A. (1995)]
"Earnings, Book Values and Dividends in Equity Valuation"
Contemporary Accounting Research, 11 (Spring), 1995.
[Ohlson and Feltham, (1995]
"Valuation and Clean Surplus Accounting for Operating and Financial Activities"
''Contemporary accounting research''
[Frankel, R., & Lee, C. M. (1998)]
Journal of Accounting and economics, 25(3), 283-319.
The theory's primary use is to estimate the
value
Value or values may refer to:
Ethics and social
* Value (ethics) wherein said concept may be construed as treating actions themselves as abstract objects, associating value to them
** Values (Western philosophy) expands the notion of value beyo ...
of a company’s shares (instead of discounted dividend/cash flow approaches). The secondary use is to estimate the
cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...
, as an alternative to e.g. the
CAPM CAPM may refer to:
* Capital asset pricing model, a fundamental model in finance
* Certified Associate in Project Management, an entry-level credential for project managers
{{Disambig ...
.
The "clean surplus" is calculated by not including transactions with
shareholder
A shareholder (in the United States often referred to as stockholder) of a corporation is an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the legal own ...
s (such as
dividends,
share repurchase
Share repurchase, also known as share buyback or stock buyback, is the re-acquisition by a company of its own shares. It represents an alternate and more flexible way (relative to dividends) of returning money to shareholders. When used in coord ...
s or share offerings) when calculating returns; whereas standard accounting for financial statements requires that the change in book value equal earnings minus dividends (net of capital changes).
Theory
The market value (MV) of the firm -- and hence security returns -- can be expressed in terms of
balance sheet and
income statement components, as below. This allows reading the firm's value directly from the balance sheet. The theory assumes ideal conditions. Here:
:The market value of a firm = net
book value of the firm’s
net assets
Net worth is the value of all the non-financial and financial assets owned by an individual or institution minus the value of all its outstanding liabilities. Since financial assets minus outstanding liabilities equal net financial assets, net ...
+
present value of future abnormal earnings (
goodwill).
:Logic:
# Goodwill is calculated as the difference between actual earnings and expected earnings ("abnormal earnings").
#* Actual earnings are the “clean surplus” - this ensures that all gains or losses go through the income statement. The impact of fair values is recognized in earnings.
#* Expected earnings = opening
shareholders' equity X the firm’s
cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...
(similar to accretion of discount.)
# Finally, convert book value to market value as above: firm value = net worth of the firm + calculated estimate of firm’s goodwill.
Applicability
This approach provides a relatively "quick and dirty" method to calculate the market value of a firm - which should be (approximately) the same as a
valuation based on discounted dividends or cash flows.
The model provides one estimate of the firm’s shares, useful for comparison to their market value. Research by Frankel & Lee
shows that this ratio provides a good predictor of share returns for 2–3 years into the future.
The model is applicable when abnormal earnings do not "persist" (i.e. no goodwill); in this case all gains and losses go through the income statement, and the firm's fair value appears on the balance sheet.
The investor can then calculate expected earnings directly from the balance sheet, as above.
However, if persistence is assumed, the income statement will have emerging "information content": this increases the impact of the income statement on firm value, and the method is less applicable.
(Greater persistence similarly translates to a greater
Earnings response coefficient.)
See also
*
Valuation (finance) #Net asset value method
*
Residual income valuation
*
T-model
References
{{reflist
External links
Accounting for dirty surplus
Financial statements
Accounting terminology
Valuation (finance)
Fundamental analysis