Earnings Power Value (EPV) is an insightful technique adopted by investors to value stocks, underpinning their assumptions on the sustainability of current earnings and the cost of capital, all the while consciously excluding prospects of future growth. Derived by dividing a company’s adjusted earnings by its weighted average cost of capital (WACC), EPV offers a straightforward yet robust formula for valuation.
While the methodology is conceptually simple, calculating adjusted earnings and WACC requires a meticulous approach. The resultant figure is known as ‘EPV equity’, which aids investors in comparing it to the company’s market capitalization to judge stock value accuracy.
Key Insights for Investors
- Valuating on Present Dynamics: EPV focuses solely on current earnings and capital costs, providing a grounding approach.
- Strategically Ignoring Specifics: Such as future growth and competitor assets, making it less speculative.
- Simplified Formula: Derived by dividing adjusted earnings by current WACC.
- Valuation Comparison: By comparing EPV equity to the market cap to assess stock valuation—be it overvalued, fairly valued, or undervalued.
The Formula and Calculation for Earnings Power Value (EPV)
1EPV = Adjusted Earnings / WACC
2
3where:
4EPV = Earnings Power Value
5WACC = Weighted Average Cost of Capital
How to Calculate Earnings Power Value
Calculating EPV begins with calculating the company’s operating earnings, or EBIT (Earnings Before Interest and Taxes), without adjustments for one-time charges. The average EBIT margins, derived from at least five years of evaluation, are multiplied by sustainable revenues to get ’normalized EBIT’.
Subsequently, normalized EBIT is adjusted by (1 - average tax rate). Excess depreciation is added back (on an after-tax basis at half the average tax rate).
Hereon, the normalized or adjusted earnings figure accounts for variables such as unconsolidated subsidiaries, restructuring charges, and pricing power. This adjusted profit figure, divided by the company’s WACC, yields the EPV of the business operations.
To determine the equity value, add ’excess net assets’ (e.g., cash and real estate minus legacy costs) to the EPV of business operations and subtract the firm’s debt value. EPV equity provides an indication of whether the stock is valued accurately or requires skepticism.
Decoding What Earnings Power Value Reveals
EPV is a powerful metric for discerning if a company’s shares are either overvalued or undervalued based on the present distributable cash flows the company can sustainably generate. The reliability of EPV arises from its utilization of known current earnings as opposed to speculative future forecasts.
EPV was introduced by the esteemed Columbia University Professor Bruce Greenwald, who aimed to refine valuation methods to sidestep the pitfalls associated with predictive valuations seen in discounted cash flow (DCF) analysis. This approach gracefully evades the uncertainties surrounding assumptions regarding future growth, cost of capital, profit margins, and necessary investments.
Limitations of Earnings Power Value
Despite its strengths, Earnings Power Value assumes persistent ideal conditions surrounding business operations, neglecting possible market or regulatory fluctuations and potential unforeseen events that may influence the business either positively or negatively.
Investors should acknowledge these limitations and use EPV in conjunction with other valuation metrics to ensure a more comprehensive analysis.
Related Terms: Adjusted Earnings, Weighted Average Cost of Capital, EBIT, Discounted Cash Flow.
References
- B. C. Greenwald, J. Kahn, E. Bellissimo, M. A. Cooper, and T. Santos. Value investing: from Graham to Buffett and beyond. John Wiley & Sons, 2020.
