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

Question

AcadiFi · Accepted Answer

The Abnormal Earnings Growth (AEG) model values equity based on capitalized next-period earnings plus the present value of future abnormal earnings growth. While the RI model anchors on book value, the AEG model anchors on forward earnings.

**Key Formula:**

V_0 = (E_1 / r) + Σ [AEG_t / (r × (1+r)^{t-1})]

Where AEG_t = EPS_t + r × DPS_{t-1} - (1+r) × EPS_{t-1}

The term (EPS_t + r × DPS_{t-1}) represents **cum-dividend earnings** -- what earnings would have been if dividends were reinvested at the required return. AEG measures the growth in earnings beyond what reinvested dividends would have produced.

**Worked Example -- Orion Aerospace (fictional)**

Given: r = 10%, E_1 = $5.00, DPS_1 = $2.00

| Year | EPS | DPS | Cum-Dividend Earnings | Normal Earnings | AEG |
|---|---|---|---|---|---|
| 1 | $5.00 | $2.00 | -- | -- | -- |
| 2 | $5.80 | $2.20 | $5.80 + 0.10 × $2.00 = $6.00 | 1.10 × $5.00 = $5.50 | $0.50 |
| 3 | $6.30 | $2.40 | $6.30 + 0.10 × $2.20 = $6.52 | 1.10 × $5.80 = $6.38 | $0.14 |
| 4+ | steady state | | AEG = 0 | | |

**Valuation:**
- Capitalized E_1 = $5.00 / 0.10 = $50.00
- PV of AEG_2 = $0.50 / (0.10 × 1.10) = $4.55
- PV of AEG_3 = $0.14 / (0.10 × 1.21) = $1.16

**V_0 = $50.00 + $4.55 + $1.16 = $55.71**

**RI vs AEG Comparison:**

| Feature | Residual Income | AEG |
|---|---|---|
| Anchor | Book value | Forward earnings (E_1/r) |
| Excess measure | (ROE - r) × Book | Earnings growth beyond required |
| Best when | Book value is reliable | Earnings forecasts are reliable |
| Sensitivity | Book value quality | Earnings growth sustainability |

The AEG model is particularly useful for companies with distorted book values (heavy intangibles, past write-offs) where anchoring on capitalized earnings provides a more stable starting point.

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

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