Earning Power Value with ValueInvesting.io
1. Definition
Earnings power value (EPV) is a technique for valuing stocks by making assumptions about the
sustainability of current earnings and the cost of capital but not future growth. Earnings power value (EPV) is
derived by dividing a company's adjusted earnings by its weighted average cost of capital (WACC). While the
formula is simple, there are a number of steps that need to be taken to calculate adjusted earnings and WACC.
Luckily, there is a stock analysis and modeling website called ValueInvesting.io
that can do that for you. Here is one example of Earning Power Value for Apple Inc.
The final result is "EPV equity," which can be compared to market capitalization.
2. Detailed calculations
Step 1: Compute average Earnings Before Interest and Tax (EBIT) margin.
The EBIT margins of the past five years (instead of one year) are considered, as the company
earnings are high in some years and low in some years. Hence, the average EBIT margin for a comprehensive
business cycle is considered. The business cycle of five years is sufficient to include high, moderate, and low
margins of a business.
Step 2: Normalize the EBIT and calculate after-tax earnings.
Normalized EBIT = Current Sales * Average EBIT margin
After Tax Normalized EBIT = Normalized EBIT * (1 – Effective Tax Rate)
Step 3: Add depreciation.
Normalized profit = After Tax Normalized EBIT + Adjusted Depreciation
Adjusted Depreciation = (0.5 * Effective Tax Rate) X Average Depreciation (5 years)
Step 4: Calculate Average Maintenance CAPEX.
Maintenance Capex = Total Capex X (1 – % Income Growth Rate)
Average Maintenance Capex = Average of Maintenance Capex in the last 5 years
Step 5: Compute Gross Earnings Power Value.
Adjusted Earnings = Normalized Profit – Average Maintenance Capex
Gross Earnings Power Value = Adjusted Earnings / WACC
Step 6: Compute Earnings Power Value.
Earnings Power Value = Gross Earnings Power Value + Excess Net Assets – Debt
Earnings Power Value per Share = Earnings Power Value/ Number of Shares Outstanding
3. Interpretation
Earnings power value (EPV) is an analytical metric used to determine if a company's shares
are over- or under-valued. It was developed by Columbia University Professor Bruce Greenwald, a renowned value
investor who, through this valuation technique, tries to overcome the main challenge in discounted cash flow
(DCF) analysis related to making assumptions about future growth, cost of capital, profit margins, and required
investments.
4. Limitations
Earnings power value is based on the idea the conditions surrounding business operations
remain constant and in an ideal state. It does not account for any fluctuations, either internally or
externally, that may affect the rate of production in any way. These risks can stem from changes within the
particular market in which the company operates, changes in associated regulatory requirements, or other
unforeseen events that affect the flow of business in either a positive or negative way.
5. Compared with Discounted Cash Flow
The discounted cash flow (DCF) approach of valuation assumes a growth rate to estimate a
company’s future cash flows. However, different analysts may assume different growth rates; thus, the company
value calculated using the DCF method varies widely. Conversely, the earnings power value approach does not
require any such assumptions and hence eliminates any speculation work. It uses numbers directly from the
company’s financial statements for calculating the intrinsic value of the company. The earnings power value
approach depends on the company’s ability to maintain constant profits. Therefore, the method helps to overcome
the challenges associated with the assumptions of profit margins, future growth, and cost of capital. However,
the earnings power value method does not consider any variations affecting business operations.
5. DCF and WACC examples:
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