What is Earnings Power Value (EPV)?
Earnings Power Value (EPV) is a valuation method that estimates a company’s intrinsic value based on its current earnings power without considering future growth. This approach is grounded in the principle that sustainable earnings are a more reliable indicator of a company’s true worth than speculative projections.
Unlike other valuation methods such as Discounted Cash Flow (DCF), which can be heavily influenced by assumptions about future growth rates and discount rates, EPV focuses on the here and now. It provides a conservative estimate by assuming that current earnings are sustainable but not necessarily growing. This makes EPV particularly useful for identifying undervalued companies with stable earnings profiles.
Steps to Calculate Earnings Power Value (EPV)
Calculating EPV involves several steps, each designed to ensure that you’re capturing the true sustainable earnings power of the company.
Step 1: Estimate Adjusted EBIT Margin
To start, you need to calculate the average EBIT (Earnings Before Interest and Taxes) margin over a period of time, typically 3-5 years. This helps smooth out business cycles and provides a more stable figure. Once you have this average margin, apply it to the current revenue to obtain normalized EBIT.
For example:
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Average EBIT Margin = (Total EBIT / Total Revenue) over 3-5 years
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Normalized EBIT = Current Revenue * Average EBIT Margin
Step 2: Calculate Normalized NOPAT
Next, apply a normalized tax rate to your adjusted EBIT to get Net Operating Profit After Tax (NOPAT). Use an average tax rate over several years to avoid distortions caused by one-off tax events.
For instance:
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Normalized Tax Rate = Average Tax Rate over 3-5 years
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NOPAT = Adjusted EBIT * (1 – Normalized Tax Rate)
Step 3: Adjust for Maintenance CapEx and Depreciation
Now, adjust your NOPAT by adding back depreciation and subtracting maintenance capital expenditures. This step is crucial because it accounts for economic depreciation adjustments.
For example:
- Adjusted NOPAT = NOPAT + Depreciation – Maintenance CapEx
Step 4: Determine Cost of Capital
Calculate the cost of capital, typically using the Weighted Average Cost of Capital (WACC). WACC combines the cost of debt and cost of equity, weighted by their respective proportions in the company’s capital structure.
For instance:
- WACC = (Cost of Debt * Debt / Total Capital) + (Cost of Equity * Equity / Total Capital)
Step 5: Calculate Adjusted Earnings
Combine the results from previous steps to calculate adjusted earnings. Include cash and deduct debt and minority interest.
For example:
- Adjusted Earnings = Adjusted NOPAT + Cash – Debt – Minority Interest
Step 6: Calculate EPV
Finally, use the formula EPV = Adjusted Earnings / Cost of Capital to calculate the Earnings Power Value. This formula reflects the present value of sustainable earnings.
For instance:
- EPV = Adjusted Earnings / WACC
Example Calculation
Let’s use Union Pacific (UNP) as an example to walk through each step.
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Estimate Adjusted EBIT Margin: Assume an average EBIT margin of 30% over 5 years.
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Calculate Normalized NOPAT: With current revenue at $20 billion, normalized EBIT would be $6 billion. Applying a normalized tax rate of 25%, NOPAT would be $4.5 billion.
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Adjust for Maintenance CapEx and Depreciation: After adding back depreciation ($1 billion) and subtracting maintenance CapEx ($500 million), adjusted NOPAT becomes $5 billion.
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Determine Cost of Capital: Assume a WACC of 8%.
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Calculate Adjusted Earnings: Including cash ($2 billion), deducting debt ($10 billion), and minority interest ($500 million), adjusted earnings are $6.5 billion.
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Calculate EPV: Using the formula EPV = Adjusted Earnings / Cost of Capital, EPV would be $6.5 billion / 0.08 = $81.25 billion.
Advantages and Limitations of EPV
The conservative nature of EPV is one of its strongest advantages. By focusing solely on current earnings power, it reduces speculation and provides a margin of safety for value investors. This approach helps avoid overoptimistic valuations that can lead to significant losses.
However, there are also limitations to consider:
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Ignoring Growth Potential: EPV does not account for potential future growth, which can undervalue companies with strong growth prospects.
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Undervaluation of Growth Companies: Companies in high-growth industries may appear undervalued using EPV because it does not capture their future earnings potential.
Despite these limitations, EPV remains a powerful tool for identifying stable companies with sustainable earnings.