The Discount Rate of Normal and Residual Earnings
34 Pages Posted: 6 Aug 2020
Date Written: June 20, 2020
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: Suggested Citation