What is Earnings Power Value?
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. The final result is “EPV equity,” which can be compared to market capitalization.
Earnings Power Value Calculation
The earnings power value is calculated through the following steps:
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.
The normalized earnings represent the earning capacity of the company that an investor can expect in the future.
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
What Does The Earnings Power Value Tell Us?
The earnings power value formula is another way to determine the intrinsic value of a company. The main difference from a discounted cash flow is the elimination of estimating growth rates, cost of capital, growth margins, and required investments
The EPV does contain the cost of capital, but it eschews the growth portion of a DCF, which is one of the main challenges of using a DCF.
Use of this formula with a DCF and any other intrinsic valuation method you choose is another tool to use to help you find a margin of safety in every investment you make.
Limitations of Earnings Power Value
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.
Interpretation of Earnings Power Value
The earnings power value is used to determine whether a company’s stock is overvalued, undervalued, or fairly valued.
A company’s stock is undervalued if the earnings power value per share of its stock is higher than the current market price of the stock.
If the earnings power value per share is lower than the existing market price, the company’s stock is overvalued.
A company’s stock is fairly valued if the earnings power value per share of the stock equals its current market value.
Since earnings power value considers only the current profit levels of the companies, the growth stocks will be valued for much less. Furthermore, if a company is not able to maintain the current level of earnings in the future, the earnings power value method will overestimate the company’s intrinsic value.