Financial Analysis - residual earnings - Essay Example

Residual earnings and its drivers According to Penman , the concept of residual earnings is about the measurement of returns that shareholders earn in their businesses on their invested capital excess from the normal expected returns. Unexpected returns comes about when a business after a certain trading period realise returns which are beyond what they it was likely to earn. This based on the initial book value of the equity of the shareholders of that particular business. Residual earnings are therefore expressed to be equal to the product of cost of the equity capital and the book value of the equity of shareholders (Diebold et al, 2012).

Pinto (2010) explains that one of the drivers of residual earnings is book value growth. Residual earnings depend on the growth in the value of the invested assets in the business. When investment is made in a business, the invested resources then start to produce earnings. With a well growing business, the investments will produce more earnings which then lead to the increased book value of the capital beyond the expected returns (Wahlen, et al 2010). This then delivers the residual earnings.

Return on common equity also is a driver of residual returns. The general returns that a business earns excess of the shareholders equity is what defines the residual earnings (Easton, 2009). When these returns therefore exceed the returns on capital that the business set to achieve, it delivers residual earnings. However, critical analysis shows that return on capital is the same as residual earnings.References listDiebold, F. X., Doherty, N. A., & Herring, R. 2012. The known, the unknown, and the unknowable in financial risk management: Measurement and theory advancing practice.

Princeton, N.J: Princeton University Press.Easton, P. D. 2009. Estimating the cost of capital implied by market prices and accounting data. Boston: NOW Pub. Penman, S. H. 2011. Accounting for value. New York: Columbia University Press.Pinto, J. E. 2010. Equity asset valuation. Hoboken. N.J: Wiley.Wahlen, J. M., Bradshaw, M., Baginski, S. P., & Stickney, C. P. 2010. Financial reporting, financial statement analysis, and valuation. Mason, Ohio: South-Western.