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 In accounting, book value (or carrying value) is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made ...

. 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 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 ne ...

, as an alternative to e.g. the CAPM. The "clean surplus" is calculated by not including transactions with

shareholder A shareholder (in the United States often referred to as stockholder) of corporate stock refers to an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the ...

s (such as

dividend A dividend is a distribution of profits by a corporation to its shareholders, after which the stock exchange decreases the price of the stock by the dividend to remove volatility. The market has no control over the stock price on open on the ex ...

share repurchase Share repurchase, also known as share buyback or stock buyback, is the reacquisition by a company of its own shares. It represents an alternate and more flexible way (relative to dividends) of returning money to shareholders. Repurchases allow s ...

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 In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...

and

income statement An income statement or profit and loss accountProfessional English in Use - Finance, Cambridge University Press, p. 10 (also referred to as a ''profit and loss statement'' (P&L), ''statement of profit or loss'', ''revenue statement'', ''statement o ...

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

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. Financial assets minus outstanding liabilities equal net financial assets, so net w ...

present value In economics and finance, present value (PV), also known as present discounted value (PDV), is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money ha ...

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 In finance, equity is an ownership interest in property that may be subject to debts or other liabilities. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets owned. For example, if someone owns a ...

X the firm's

(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 In financial economics, finance, and accounting, the earnings response coefficient, or ERC, is the estimated relationship between equity returns and the unexpected portion of (i.e., new information in) companies' earnings announcements. Developme ...

References

External links

Accounting for dirty surplus

{{Authority control Financial statements Accounting terminology Valuation (finance) Fundamental analysis

Theory

Applicability

See also

References

External links