1) Explain how the residual earnings valuation model (REM) is based on the dividend valuation model (DVM) and discuss how the REM provides insights into the drivers of a firm’s price-to-book ratio.
Tips: A detailed description of the REM should be provided, preferably accompanied by an accurate algebraic representation highlighting the key role of the clean surplus relation. The importance of excess ROE over the cost of equity and growth in the book value of equity, as drivers of value should then be highlighted. The effect of accounting conservatism (particularly when firms invest in intangibles not recognized on the balance sheet) on ROE and price-to-book ratios should be explained.
2) Explain how the abnormal earnings growth valuation model (AEGM) is based on the DVM and discuss how the AEGM provides insights into the drivers of a firm’s price-earnings ratio.
Tips: A detailed description of the AEGM should be provided, preferably accompanied by an accurate algebraic representation. The importance of the ability of the firm to reinvest earnings above the cost of equity leading to a price-earnings ratio greater than the reciprocal of the cost of equity should be highlighted. In contrast to the REM, it should be noted that the AEGM is not based on the clean surplus relation, as book value does not play a role. The focus on earnings is arguably more consistent with the focus of analysts on earnings per share growth.