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Vera Yuan
Vera Yuan
Articles (1063) 

New Feature Announcement: Earnings Power Value

November 25, 2014 | About:

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.

If you are not a Premium Member, we invite you for a 7-day Free Trial.


Rating: 4.6/5 (9 votes)

Voters:

Comments

ramos285
Ramos285 premium member - 2 years ago

"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 undervalued"? is undervalued or overvalued i think is overvalued is correct?

Vera
Vera premium member - 2 years ago

Hi Ramos,

Sorry I made a mistake. Thanks for pointing this out.

Vera

Rick1952
Rick1952 premium member - 2 years ago

Very interesting analysis but I believe the conclusion is incorrect. Based on your analysis, WMT would be overvalued.

Vera
Vera premium member - 2 years ago

Hi Rick1952,

I've updated the article and corrected it. Thanks for pointing this out.

Vera

Praveen Chawla
Praveen Chawla premium member - 2 years ago

Great feature. Some times you run into problems esp with companies which have undergone big changes lately like acquisitions or divestures and do not have 5 years of history, Example is ABT which spun off ABBV, This results in a incorrect value. Users should be alert to this issue and adjust around it.

Tannor
Tannor - 2 years ago    Report SPAM

Cool new feature,

I have a question.

How is WACC being calculated at 9% for EPV business operations? I thought it was likely too high and when dropped to 6% PPS value is $100. Is it arbitrarily chosen re: point 7

Thanks.

Vera
Vera premium member - 2 years ago

Hi Tannor,

This is the number I've set for required cost of capital. Not the actually WACC calculated by cost of equity and cost of debt. GuruFocus database does not have beta value to calculate the cost of equity. Therefore I cannot get the exact WACC number through calculation.

My "WACC" here is like the Discount Rate in DCF calculator. Investors can set their own required cost of capital.

Vera

Tannor
Tannor - 2 years ago    Report SPAM

Thanks Vera!

ramos285
Ramos285 premium member - 2 years ago

Vera you said "Normalized" EBIT = Sustainable Revenue * Average Operating Margin + Average Adjusted SGA = 456333.8 * 5.8345% +21836.5 = $48461.295561 Mil" but i think is nt correct , because we must remove and not add "Average Adjusted SGA.

Normalized EBIT= Sustainable Revenue * Average Operating Margin -Sustainable Revenue * Average Operating Margin . Do you agree?

ramos285
Ramos285 premium member - 2 years ago

Excess Depreciation = Average DDA * % of Excess Depreciation (at 1/2 average tax rate) = 8380.4 * 0.5 * 32.2705% = $1352.198491 Mil. this number 8380.4 how to calculate?

batbeer2
Batbeer2 premium member - 2 years ago

Hi Pravchaw,

You say:

>> Some times you run into problems esp with companies which have undergone big changes lately like acquisitions or divestures and do not have 5 years of history, Example is ABT which spun off ABBV, This results in a incorrect value. Users should be alert to this issue and adjust around it.

I disagree.

When there are no acquisitions or diverstitures, the value that is arived at is in no way more correct than a value that arises when there are.

When there are lots of moving parts, you don't need to warn users. That's when they will probably be using their heads anyway. Instead, it is when a model spits out a nice number for a company that churns out nice steady revenue and margins that there should be a big red warning sign.

In other words, it is not ABT that risky, it is Whiting Petroleum Trust. That one looks much better on paper and that is probably why from time to time you will find articles on the Internet explaining why it is a great long.

soicowboy
Soicowboy - 2 years ago    Report SPAM

I still don't like the conclusion.

IMO

$61.69, is the no-growth value

$84.52. is the market price

$84.52 minus $61.69 = $22.83 represents the amount that the market is assigning for future growth.

If you can find a company trading near or below its EPV that is obviously growing then you may have a bargain.

drossi
Drossi - 2 years ago    Report SPAM

EPV is a valuable calculation, but be careful using GuruFocus "ready-to-use" calculations. They often misrepresent numbers, opting for simplistic calculations that can significantly over/understate financials... I'm a premium user and have pointed quite a few distortions to gurufocus' staff, so beware.

drossi
Drossi - 2 years ago    Report SPAM

In other words, identify companies using the EPV tool and then do you own homework.

;-)

kmadnani
Kmadnani premium member - 2 years ago

How can I use my own discount rate in this EPV calculation?

idaustin
Idaustin - 2 years ago    Report SPAM

Why are you adding back 25% of SG&A? Have you analyzed the correlation between SG&A in order to determine if SG&A is statistically significant In terms of sales? If they never built another store, would they need to spend $.25 per $1 of existing sales in order to coerce existing customers to continue shopping?

nickzarifeh
Nickzarifeh - 1 year ago    Report SPAM

Hi Vera,

Thanks for the summary of Greenwald's EPV calculation, very nice. I'm in the process of reading his book Value Investing and note that he compares EPV to AV. AV being Asset Value. Have you by any chance written an article on how to Calculate the Asset Value?

Thanks and regards

Nick

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