Learn how the excess return model values a company by assessing the returns generated above its required cost of capital.
The excess return model values a company by estimating returns generated above its required cost of capital. It helps assess whether management is generating or eroding shareholder value. This approach is commonly applied in fundamental equity valuation.
Excess return represents the additional return a company generates over the minimum return required by its investors (typically the cost of equity).
In other words, it measures how much value a business adds after accounting for opportunity costs.
Excess Return = Actual Return on Equity (ROE) – Cost of Equity (Ke)
If a firm’s ROE is higher than its Ke, it creates positive value; if lower, it destroys value.
If a company’s ROE is 15% and its cost of equity is 10%, the excess return equals 5% — indicating higher capital efficiency.
This concept underpins models like Residual Income (RI) and Economic Value Added (EVA), where firm value is derived from expected future excess returns.
The Excess Return Model (ERM) values a company by summing the present value of expected excess returns to its book value of equity:
Value of Equity = Book Value of Equity + Σ [ (ROE_t - Ke) × Book Value_(t-1) ] / (1 + Ke)^t
This approach aligns valuation with economic profitability rather than accounting profits.
Firms with ROE > Ke increase intrinsic value.
Firms with ROE = Ke maintain value.
Firms with ROE < Ke erode shareholder value.
Under the assumption of constant growth, the simplified single-stage model is expressed as:
Value = Book Value + [ (ROE - Ke) × Book Value ] / (Ke - g)
Where:
ROE = Return on Equity
Ke = Cost of Equity
g = Growth rate of residual income
Use Case: Suitable for mature firms with stable profitability and growth patterns.
When a company’s profitability changes over time — such as high early returns normalising later — a multi-stage model is more accurate:
Stage 1: Forecast varying excess returns for a defined high-growth period.
Stage 2: Assume stable returns (ROE → Ke) in perpetuity.
Discount each stage’s residual income to present value and sum with the book value.
Use Case: Applicable to growth companies or cyclical firms where ROE changes significantly over time.
Several well-known frameworks are derived from the ERM, differing mainly in how they express “excess returns”:
| Model | Basis of Calculation | Focus |
|---|---|---|
Residual Income Model (RIM) |
ROE – Ke |
Focuses on accounting profits |
Economic Value Added (EVA) |
NOPAT – (WACC × Capital) |
Emphasises total capital returns |
Abnormal Earnings Growth Model (AEG) |
Δ Earnings – (Ke × Previous Earnings) |
Focuses on earnings momentum |
Market Value Added (MVA) |
Market Value – Invested Capital |
Captures market-perceived value creation |
Each version highlights how excess profitability leads to value creation beyond book capital.
To implement the Excess Return Model, analysts need:
Book Value of Equity (BV): From the balance sheet.
Forecasted ROE: Based on profitability projections.
Cost of Equity (Ke): Usually estimated via CAPM.
Growth Rate (g): Assumed for the stable period.
Forecast Period: Duration of value-creating returns.
Note: Reliable financial projections are important— small errors in ROE or Ke can significantly alter valuation outcomes.
| Parameter | Value |
|---|---|
Book Value (BV) |
₹500 crore |
Expected ROE |
15% |
Cost of Equity (Ke) |
10% |
Growth Rate (g) |
4% |
Value = 500 + [ (0.15 - 0.10) × 500 ] / (0.10 - 0.04)
Value = 500 + 25 / 0.06
Value = 500 + 416.7
Value = ₹916.7 crore
Interpretation:
The company’s intrinsic value is estimated at ₹916.7 crore — nearly 1.8× its book value, reflecting positive value creation.
Here’s how the Excess Return Model compares with DCF and Residual Income approaches in valuation focus and application:
| Aspect | Excess Return Model (ERM) | Discounted Cash Flow (DCF) | Residual Income (RI) |
|---|---|---|---|
Basis |
Return on equity over cost |
Free cash flows |
Accounting income |
Starting Point |
Book value of equity |
Free cash flow projections |
Book value + residuals |
Focus |
Value from excess profitability |
Value from cash generation |
Value from abnormal income |
Suitable For |
Firms with stable ROE |
Firms with predictable cash flows |
Accounting-based analysis |
Ease of Use |
Moderate |
Complex |
Moderate |
Summary:
The ERM simplifies valuation by focusing on profitability over required returns — often more intuitive than DCF for analysts emphasising accounting metrics, particularly when considering events like the ex-dividend date.
Here are the main challenges and constraints to keep in mind when applying the Excess Return Model:
Sensitive Inputs: Small variations in ROE or Ke cause major changes in results.
Assumed Stability: Requires steady ROE and growth assumptions.
Accounting Dependence: Relies on accurate book value and earnings data.
Ignores Market Factors: Doesn’t directly capture sentiment or liquidity.
Complex Forecasting: Multi-stage models require detailed long-term projections.
The Excess Return Model (ERM) highlights how effectively a company generates returns beyond the cost of equity — a core measure of true value creation. It bridges profitability and valuation by focusing on economic performance rather than accounting figures.
The Excess Return Model (ERM) measures value creation above the cost of equity.
It links valuation directly to economic profitability and shareholder returns.
Commonly applied to firms with measurable ROE and stable accounting data.
It’s conceptually related to Residual Income (RI) and EVA, but emphasises equity-driven value.
Works well as a complementary approach to DCF in financial modeling.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
The Excess Return Model (ERM) is a valuation approach that estimates a company’s intrinsic value based on returns generated above the cost of equity. It focuses on assessing profitability and value creation beyond the required investor return.
The model is derived from the residual income approach, where a firm’s value equals its book value of equity plus the present value of all expected future excess returns. These excess returns represent the profit earned over and above the cost of equity capital.
The key inputs influencing ERM valuations are Return on Equity (ROE), Cost of Equity (Ke), and Growth Rate (g). Small changes in any of these variables can significantly affect the final valuation outcome.
The Excess Return Model is a broader form of the Residual Income Model. Both assess value by measuring the difference between actual accounting returns and the required rate of return, with excess return representing abnormal profitability.
Common variants of the Excess Return Model include Economic Value Added (EVA), Residual Income, Abnormal Earnings Growth, and Market Value Added (MVA). Each of these frameworks evaluates economic profit or performance relative to the cost of capital.