The Discount Rate of Normal and Residual Earnings

34 Pages Posted: 6 Aug 2020

Date Written: June 20, 2020

Abstract

We extend the original idea of the residual income model and decompose the firm’s cost of equity capital into its two elementary components: The discount rate of normal operating earnings (kNE) and discount rate of residual operating earnings (kRE). The first part of the paper identifies the analytical relation between the firm’s cost of capital, kNE and kRE for the un-levered firm in steady state conditions. The second part of the paper empirically tests this relation by exploiting the cross section of firm’s operating profitability (RNOA) and enterprise price-to-book ratio (PNOA/NOA). Our findings support the idea that residual earnings are the less risky component of income.

Keywords: Cost of Capital, Residual Income Model, Operating Risk

JEL Classification: M41

Suggested Citation

Reggiani, Francesco, The Discount Rate of Normal and Residual Earnings (June 20, 2020). Available at SSRN: https://ssrn.com/abstract=3648054 or http://dx.doi.org/10.2139/ssrn.3648054

Francesco Reggiani (Contact Author)

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

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