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.
The "clean surplus" is calculated by not including transactions with shareholders (such as dividends, share repurchases or share offerings) when calculating returns; whereas standard accounting for financial statements requires that the change in book value equal earnings minus dividends (net of capital changes).
Here: This approach provides a relatively "quick and dirty" method to calculate the market value of a firm - which should be (approximately) the same as a valuation based on discounted dividends or cash flows.
Research by Frankel & Lee[3] shows that this ratio provides a good predictor of share returns for 2–3 years into the future.
The model is applicable when abnormal earnings do not "persist" (i.e. no goodwill); in this case all gains and losses go through the income statement, and the firm's fair value appears on the balance sheet.