What is the Abnormal Earnings Growth (AEG) model and how does it differ from residual income?

Question

AcadiFi · Accepted Answer

The Abnormal Earnings Growth (AEG) model — also associated with Ohlson and Juettner-Nauroth — takes a different angle on the same fundamental concept. While residual income anchors on book value, AEG anchors on capitalized next-period earnings.

**Conceptual Framework:**

**Residual Income:** Value = Book Value + PV(future residual income)
**AEG:** Value = Capitalized Forward Earnings + PV(future abnormal earnings growth)

**The AEG Logic:**
Start by capitalizing next year's earnings as a no-growth perpetuity: E_1/r. Then add value for any earnings growth beyond what's normal (i.e., beyond the required return reinvested at the required return).

**Abnormal Earnings Growth Defined:**

AEG_t = E_t - (E_{t-1} + r x E_{t-1}) = E_t - E_{t-1}(1 + r)

In plain English: AEG is the portion of earnings growth that exceeds what you'd expect if the firm simply reinvested prior earnings at the cost of equity.

**Simplified Two-Period AEG Valuation:**

V_0 = (1/r) x [E_1 + AEG_2 / (r - g)]

Where g is the long-run growth rate of abnormal earnings.

**Worked Example:**
Quantum Logistics has:
- E_1 (forward EPS): $6.00
- E_2 (year 2 EPS): $7.20
- Dividends per share (D_1): $2.00
- Cost of equity (r): 12%
- Long-run AEG growth (g): 3%

Step 1: Calculate cum-dividend earnings growth
E_2 + r x D_1 = $7.20 + 0.12 x $2.00 = $7.44

Step 2: Normal earnings growth
E_1 x (1 + r) = $6.00 x 1.12 = $6.72

Step 3: AEG_2 = $7.44 - $6.72 = $0.72

Step 4: Value
V_0 = (1/0.12) x [$6.00 + $0.72 / (0.12 - 0.03)]
V_0 = 8.333 x [$6.00 + $8.00]
V_0 = 8.333 x $14.00
V_0 = **$116.67**

**When to Use AEG vs. Residual Income:**

| Criterion | AEG Preferred | RI Preferred |
|-----------|--------------|---------------|
| Book value reliability | Unreliable (tech, services) | Reliable (banks, industrials) |
| Earnings forecasts | Readily available | May be volatile |
| Clean surplus holds? | Less sensitive to violations | Requires clean surplus |
| Analyst coverage | Strong consensus estimates | Book value data available |

**Exam Tip:** The AEG model is particularly testable because it connects directly to P/E ratios — a stock with positive AEG deserves a higher-than-normal P/E. Be ready to compute AEG from given earnings and dividend data.

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What is the Abnormal Earnings Growth (AEG) model and how does it differ from residual income?

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