Methodology
This page explains how the Reality Gap (RG) indicator is constructed and what it measures. For the complete formal derivation, please refer to the working paper.
What Does RG Measure?
The Reality Gap indicator measures whether a company's current market capitalisation is approximately covered by an estimated fundamental base. The fundamental base is derived from a combination of smoothed earnings and tangible equity.
A higher RG value indicates a larger gap between market valuation and the estimated fundamental base — meaning the market is pricing the company at a significant multiple of what the fundamentals alone would support.
A lower RG value suggests that the market price is closer to being covered by the fundamental base.
What RG Does Not Measure
- RG is not an intrinsic value model. It does not claim to determine a company's "true" or "fair" value.
- RG is not a price target. It does not imply that a stock is overvalued or undervalued in any actionable sense.
- RG is not an investment recommendation. It is a descriptive, heuristic indicator intended for analytical and research purposes.
- The indicator should be interpreted with caution, particularly for companies with limited operating history, unusual capital structures, or non-standard earnings patterns.
RG Variants: RG8, RG10, RG12
The subscript N (8, 10, 12) is the capitalization factor — not a smoothing window. G is computed once using a single fixed rule and enters the formula with three different multiples:
RG8
RG₈ = MC / (TE + 8×G). Uses a capitalization factor of 8. The most conservative assumption: only 8 years of smoothed earnings are assumed to justify the earnings component. With the same G and TE, RG8 ≥ RG10 ≥ RG12.
RG10
RG₁₀ = MC / (TE + 10×G). Uses a capitalization factor of 10. The primary reference variant.
RG12
RG₁₂ = MC / (TE + 12×G). Uses a capitalization factor of 12. The most generous assumption: 12 years of smoothed earnings justify the earnings component. Produces the lowest RG of the three.
G is smoothed over the last 8 available quarters (annualized). N is the capitalization factor — not the averaging window. RG10 is the primary ranking metric.
Trend Codes
Each observation carries a trend code indicating the recent directional change in the RG value:
| Code | Meaning | Description |
|---|---|---|
| ++ | Strongly Increasing | RG has increased significantly in recent quarters. |
| + | Increasing | RG has increased moderately in recent quarters. |
| = | Approximately Stable | RG has remained broadly unchanged. |
| - | Declining | RG has declined moderately in recent quarters. |
| -- | Strongly Declining | RG has declined significantly in recent quarters. |
Trend codes are computed per observation and reflect the direction of change, not the absolute level.
Key Concepts
Tangible Equity
Book equity adjusted for goodwill and other intangible assets. Used as a floor component in the fundamental base calculation.
Smoothed Earnings
An average of net income across the observation window (8, 10, or 12 quarters). Smoothing reduces the impact of one-time items and cyclical distortions.
Fundamental Base
An approximate combined measure of earnings capacity and tangible equity. Used as the denominator in the RG ratio.
Heuristic Indicator
RG is explicitly a heuristic — a practical approximation tool. It is designed to be informative and consistent, not to be a precise or definitive valuation model.
Full Methodology
For the complete formal derivation, assumptions, limitations, and worked examples, please refer to the working paper.
Read the Working Paper