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As an alternative to Residual Income model, another simple and effective tool to breakdown components of firm’s share price is to use AEG model, which relies on the forward earnings and abnormal future earnings growth. Accordingly, the share price is broken into
Value from Capitalized Current Year Earnings
• Economic Nature: these are firm values based on current (year 1) operations, which is derived from the firm continuing the current operating forever, assuming the same profit conditions persist.
• Accounting measure: PV of forecasted year-1 earnings as a perpetuity (or capitalized).
Value from Capitalized Short- and Medium-term AEG
• Economic Nature: these are firm values from forecasted earnings growth (beyond year-1) over-and-above expected growth. These earnings momentum may come from current growth strategy paying off.
• Accounting measure: for every year under consideration (e.g., year-3, -4, … -7 in our class template), Step-1: compute AEG; Step-2, take PV of AEG as of year-1 (not today); Step-3: capitalize this AEG (i.e., compute the PV of this year-1 value of AEG as a perpetuity; Step-4, repeat this for the next year till yer-7.
Value from the Future AEG (Speculation)
• Economic Nature: these are firm values based on any future deviations such as changing strategies, which are not incorporated in the previous two components.
• Implied Measure from Market Price: Value from the future AEG = Share Price – Value from the previous two components.
Sample Solution