Earnings Power Value, also known as just Earnings Power, is a valuation technique popularized by Bruce Greenwald, an authority on value investing at Columbia University. It is arguably a better way to analyze stocks than Discounted Cash Flow analysis that relies on highly speculative growth assumptions many years into the future.
The basic concept of EPV is that one should value a stock based on the current free cash flow of a company and not on future projections which may, or may not, come true. This valuation tool excludes the potential growth that a company may have so that needs to be looked at separately. Since future growth is excluded from the analysis, only the maintenance capital expenditures are subtracted from after-tax EBIT (earnings before interest and taxes) and growth CAPEX is ignored.
The underline assumption of EPV is that the current profitability is sustainable.
To understand the investment process, please read the Greenwald's lecture notes (start from page 15) from Columbia business school.
Bruce Greenwald's Value Investing: From Graham to Buffett and Beyond successfully bridges the gap between the traditional Graham & Dodd style of value investing to what works today.
“In Chapter 3 we defined the EPV of a firm as earnings after certain adjustments times 1/R, with R representing the current cost of capital. The adjustments to earnings we mentioned were
1. Undoing accounting misrepresentations, such as frequent one-time charges that are supposedly unconnected to normal operations. The adjustment consists of finding the average ratio that these charges bear to reported earnings before adjustments, annually, and reducing the current year's reported earnings before adjustment proportionally.
2. Resolving discrepancies between depreciation and amortization, as reported by the accountants, and the actual amount of reinvestment the company needs to make in order to restore a firm's assets at the end of the year to their level at the start of the year. The adjustment adds or subtracts this difference.
3. Taking into account the business cycle and other transient effects. The adjustment reduces earnings reported at the peak of the cycle and raises them if the firm is currently in a cyclical trough.
4. Applying other modifications as are reasonable, depending on the specific situations.
The purpose of these adjustments is to arrive at a figure that represents distributable cash flow, or money the owners can extract from the firm ad still leaves its operations intact.”
The Formula
EPV Business Operations = Earnings Power * 1 / WACC
EPV = (EPV Business Operations + Cash – Interest Bearing Debt) / Shares Outstanding
Earnings Power Value Calculation
Use Wal-Mart Stores Inc (WMT) as an example. The latest quarter end is Oct. 31, 2014.
1. Start with "Earnings" not including accounting adjustments (one-time charges not excluded unless policy has changed). "Earnings" are "Operating earnings" (EBIT).
2. Look at average margins over a business / Industry cycle
To normalize margins and eliminate the effects on profitability of valuing the firm at different points in the business cycle, it is usually best to take a long-term average of operating margins. Ideally this would be as long as 10 years and include at least one economic downturn. However, since most of companies do not have as long as 10-year history, here GuruFocus uses the latest 5 years data to do the calculation. To smooth out unusual years but reflect recent developments, we take an average of the 5 year margins.
For companies reported quarterly, we use the latest 20 quarters (equivalents to 5 years) data to get the average margin. The reason for using quarterly data instead of the latest 5 fiscal year end data is simple. GuruFocus believes that the most recent data should be included in order to give the best results possible.
Note: for companies reported semi-annually, we use the fiscal year end data instead of semi-annual data because sometimes semi-annual data is incomplete.
The 5-year average operating margin for Wal-Mart Store Inc is 5.8345%.
3. Multiply average margins by sustainable revenues and then adjust for maintenance SGA. This yields "Normalized" EBIT:
To be conservative, GuruFocus uses an average of the 5-year revenues as the sustainable revenue.
EPV analysis recognizes that part of SG&A expenditure is made to maintain and replace the existing assets, while part is made to grow sales. Since EPV is only interested in what it costs a going concern to maintain its existing asset base, it adds back a percentage of SG&A (between 15% and 50% - this is a matter of judgment and industry knowledge) to make up for the fact that some of this expenditure went to fund growth and shouldn't be accounted for. To start off, we assume 25% for the sake of prudence.
Note: we take an average of last 5-year (20-quarter) quarterly revenue and then times four to get the annualized average revenue. The same practice for annualized average SGA.
Sustainable Revenue = $456333.8 Mil, Average Operating Margin = 5.8345%, Average Adjusted SGA = $21836.5 Mil,
"Normalized" EBIT = Sustainable Revenue * Average Operating Margin + Average Adjusted SGA = 456333.8 * 5.8345% +21836.5 = $48461.295561 Mil.
4. Multiply by one minus Average Tax Rate (NOPAT):
Same as average operating margin calculation, GuruFocus takes an average of the 5 years quarterly tax rates.
Average Tax Rate = 32.2705%, and "Normalized" EBIT = $48461.295561 Mil,
After-tax "Normalized" EBIT = "Normalized" EBIT * ( 1 - Average Tax Rate ) = 48461.295561 * ( 1 - 32.2705% ) = $32822.593177 Mil.
5. Add back excess depreciation (at 1/2 average tax rate). This yields "Normalized" Earnings:
Excess Depreciation = Average DDA * % of Excess Depreciation (at 1/2 average tax rate) = 8380.4 * 0.5 * 32.2705% = $1352.198491 Mil.
"Normalized" Earnings = After-tax "Normalized" EBIT + Excess Depreciation = 32822.593177 + 1352.198491 = $34174.791668 Mil.
6. Adjusted for Maintenance Capital Expenditure:
As mentioned above, the basic concept of EPV is that one should value a stock based on the current free cash flow of a company and not on future projections which may, or may not, come true. This valuation tool excludes the potential growth that a company may have so that needs to be looked at separately. Since future growth is excluded from the analysis, only the maintenance capital expenditures are subtracted from after-tax EBIT (earnings before interest and taxes) and growth CAPEX is ignored. The following is the method to calculate the maintenance capital expenditure:
First, calculate the revenue change regarding to the previous year. If the revenue decreased from the previous year: Maintenance CAPEX = Capital Expenditure (positive)
Second, if the revenue increased from the previous year, then calculate the percentage of Net PPE as of corresponding Revenue.
Growth CAPEX = Percentage of Net PPE as of corresponding Revenue * Revenue Increase
Third, calculate Capital Expenditure (positive) - Growth CAPEX.
If [Capital Expenditure (positive) - Growth CAPEX] was negative, then the
Maintenance CAPEX = Capital Expenditure (positive).
If [Capital Expenditure (positive) - Growth CAPEX] was positive, then the
Maintenance CAPEX = Capital Expenditure (positive) - Growth CAPEX
Fourth, GuruFocus uses an average of the 5 year maintenance capital expenditures as maintenance CAPEX.
Wal-Mart Stores Inc's Average Maintenance CAPEX = $11779.5045 Mil.
7. Investors require a return of "WACC" for the risk they are taking.
Investors can choose their own require rate of return. Here we choose 9% as “WACC”.
8. Cash and Debt Adjustments.
“If we intend to compare the EPV to the market price, we need to make one final adjustment. The EPV assumes that all the capital is equity capital; it ignores both interest paid on debt and interest received on cash. If there is debt, it has to be subtracted from the EPV. If there is cash in excel of operating requirements, it should be added back. Only then can we compare the total EPV with the market price of the equity.”
So the final step is to subtract out any corporate debt and add in cash in excess of operating requirements and divide this by the number of shares to get the EPV per share value.
Wal-Mart Stores Inc's current (as of Oct. 31, 2014) cash and cash equivalent = $6718 Mil.
Wal-Mart Stores Inc's current interest bearing debt = Long-Term Debt + Short-Term Debt = 44487 + 11195 = $55682 Mil.
Wal-Mart Stores Inc's current diluted shares outstanding = 3240.000 Mil.
EPV Business Operations = Earnings Power * 1 / WACC
= ("Normalized" Earnings - Average Maintenance CAPEX) * 1 / WACC
= ( 34174.791668 - 11779.5045 ) / 9%
=$248836.5244 Mil
Note: If average maintenance CAPEX is negative, then EPV Business Operations = "Normalized" Earnings * 1 / WACC.
EPV = (EPV Business Operations + Cash – Interest Bearing Debt) / Shares Outstanding
= ( 248836.5244 + 6718 – 55682 ) / 3240
= $61.69
Conclusion
From above calculation, we can estimate the current earnings power value for Wal-Mart Stores Inc is $61.69, the current share trading price for now is $84.52. In this concept, Wal-Mart Stores Inc (WMT) is overvalued.
Please note, this method values company based on current situations and it does not depend on future predictions. However, it may undervalue the growth companies. The underline assumption of EPV is that the current profitability is sustainable. If the current profitability is not sustainable, the calculated EPV will be high. Generally speaking, this is a very conservative way to value stock.
GuruFocus creates term pages which you can see the EPV calculation for all the stocks. Just enter the symbol you want to see in the box right under the Definitions tab, and click Go.
Also on the left of the page and under Summary tab, you can enter other terms you want to see and click on them.
On the left of the share price chart, there is a valuation box which will also displays EPV value, as well as intrinsic values generating from other valuation methods.
GuruFocus also adds Price/EPV in All-in-One Guru Screener. Click Valuation Ratio tab right next to Fundamental tab, on the fourth column, there is one called Price/Earnings Power Value. You can set up the range you want, and see a list of stocks which qualifies this criterion.
In using this screener, please remember that this is an idea generator and that further research and a more detailed valuation should be performed. Each stock is an individual case which warrants deeper study.
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