What Is Earnings Power Value (EPV)?
Let me explain Earnings Power Value, or EPV, directly to you. It's a stock valuation technique where I make assumptions about the sustainability of a company's current earnings and its cost of capital, but I completely ignore any future growth. You derive EPV by dividing the company's adjusted earnings by its weighted average cost of capital, known as WACC.
The formula might seem simple, but you need to follow several steps to calculate those adjusted earnings and the WACC accurately. In the end, you get what's called 'EPV equity,' which you can compare directly to the company's market capitalization to see if the stock is priced right.
Key Takeaways
- EPV focuses on a firm's current cost of capital for stock valuation.
- It overlooks key factors like future growth and assets of competitors.
- You calculate EPV by dividing adjusted earnings by WACC.
- Compare EPV equity to market capitalization to assess if the stock is fairly valued, overvalued, or undervalued.
Formula and Calculation for Earnings Power Value (EPV)
Here's the core formula for EPV: EPV equals adjusted earnings divided by WACC, where EPV stands for earnings power value and WACC is the weighted average cost of capital.
To calculate it, start with operating earnings, or EBIT—earnings before interest and tax—without adjusting for one-time charges yet. Take the average EBIT margins over at least a five-year business cycle and multiply by sustainable revenues to get your 'normalized EBIT.'
Next, multiply that normalized EBIT by (1 minus the average tax rate). Then add back excess depreciation on an after-tax basis, using half the average tax rate. Now you have the firm's 'normalized' earnings. Make further adjustments for things like unconsolidated subsidiaries, current restructuring charges, pricing power, and other significant items.
Divide this adjusted earnings figure by the WACC to get the EPV of business operations. Finally, to find the EPV equity, add excess net assets—such as cash and market value of real estate minus legacy costs—to the EPV business operations, and subtract the firm's debt. Compare this EPV equity to the current market capitalization to judge the stock's value.
Remember, EPV represents the current free cash flow capacity of the firm, discounted at its cost of capital.
What Does Earnings Power Value Tell You?
EPV is an analytical tool I use to figure out if a company's shares are overvalued or undervalued. The formula calculates the level of distributable cash flows that the company can reasonably sustain based on current earnings, which are reliable and known, rather than relying on forecasts or discounted future earnings.
This makes EPV more dependable than many other metrics that involve assumptions or subjective judgments. It was developed by Columbia University Professor Bruce Greenwald, a noted financial economist and value investor. His goal with EPV is to address the big challenges in discounted cash flow (DCF) analysis, like assuming future growth, cost of capital, profit margins, and required investments.
Limitations of Earnings Power Value
EPV assumes that business conditions stay constant and ideal, which isn't always the case. It doesn't account for any fluctuations—internal or external—that could impact production rates.
These risks might come from changes in the market where the company operates, shifts in regulatory requirements, or other unexpected events that could positively or negatively affect business flow.
