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.
Contents
Description
Clean surplus accounting is calculated by not including transactions with shareholders (such as dividends, share repurchases or share offerings) when calculating returns. Current accounting for financial statements requires that the change in book value equal earnings minus dividends (net of capital changes).
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 as an alternative to CAPM to estimate the cost of capital.
The theory is consistent with the measurement perspective. MV (market value) of the firm (hence security returns) can be expressed in terms of balance sheet (B/S) and income statement (I/S) components. The theory assumes ideal conditions.
The market value of a firm = net book value of the firm’s net assets + present value of future abnormal earnings (goodwill). This allows reading the firm's value directly from the balance sheet.
Key Points: 1 Actual earnings are based on “clean surplus” - ensures that all gains or losses go through the income statement. The impact of fair values is recognized in earnings. 2 Goodwill is calculated as the difference between actual and expected earnings (the same concept as abnormal earnings). 3 Expected earnings - opening shareholders’ equity X firm’s cost of capital (similar to accretion of discount.) 4 Net worth of the firm + calculated estimate of firm’s goodwill = firm value. (Converts book value to market value.
Benefits
This approach provides a relatively quick and dirty method to calculate the “market value” of a firm. It should be the same as valuation from discounted dividend and cash flow model. The F&O model provides one estimate of the firm’s shares and for comparison to their market value. Research (Frankel & Lee 1998) shows that the ratio of this calculation was a good predictor of share returns for 2–3 years into the future.
When accounting is not manipulated and abnormal earnings do not persist (i.e. no goodwill), all of the firm's value appears on the balance sheet. Note: all gains and losses go through the income statement. Fair values used in income statement should not produce abnormal earnings. Thus the balance sheet shows fair values.
Since state realizations typically come into subsequent years, the effect of persistence comes into play:
A balance sheet prepared with present values has all information on the balance sheet and none in net investment (since investor can calculate expected earnings directly from the balance sheet). The same principle applies to clean surplus theory unless there is persistence of earnings.
Once persistence is factored in, all the action is no longer in the balance sheet even with ideal conditions.