For many, the art of value investing may seem to be decidedly “kludgy”.
Strict value investors refuse to consider the future prospects of the company. Estimates are inherently risky. We do not have a fool proof way of making estimates, and future has a way of not sticking to our expectations. So we dispense with the future estimates in making our valuation call. The past, as we believe, has already come to pass, and therefore the numbers are reliable (not always, but I digress), and so we decide we will only consider the historical data in our analytical process.
This was all fine and dandy in the days of Benjamin Graham. The markets were less efficient and more laissez-faire. Extreme deviations from the asset values were more common. Therefore the strict Grahamian approach to valuation yielded investment candidates in sufficient quantities to keep a dyed in the wool value investor busy.
But what to do when there are trading bots waiting to exploit every nano-second of inefficiency? Active investors today are ready to pounce on every asset where the market value deviates from the intrinsic value. Carve outs, spin offs, mergers, acquisitions, board room battles, roll-ups, going private transactions are all too common now. The traditional value investing approach of sticking to the balance sheet does not work very well anymore, except in the dark corners of the market where there is less attention and less liquidity.
A different approach to valuation is/was needed.
Earnings Power Value: An Incremental Improvement to the Intrinsic Value Calculation
If the past data is less effective, the future data is unreliable, then why not consider the “Present”?
We will make a concession, and consider the earnings as part of the valuation. However, we are not yet ready to go as far as estimate the future earnings. What we are willing to do, however, is to consider the current earnings, and use this to value the company assuming that this level of earnings will be sustained. AKA no-growth model of valuation.
Prof. Greenwald took this insight and developed it into the Earnings Power Value method of valuation. We will take a brief look at this in a minute, but before that I want to take you through a quick insight or two.
Philosophically, What is Earnings Power Anyway?
It is a measure of a company’s ability to wring out profits from its business operations. The more efficient the operations are, the better able the company is to generate higher profits per unit of inputs.
The Basic Earning Power Formula is expressed as Operating Earnings/Total Assets.
Or, BEP = EBIT/Total Assets
Sometimes, the earning power is also expressed as EBIT/Equity. No matter what is used, the idea is to express a business’ ability to generate profits based on what it has. It is inherently assumed that the business conditions will continue to persist as they are. Note that EBIT is used instead of Net Earnings, and therefore the value will be different from the ROA or ROE calculation. This way, the effects of taxation and capital structure are eliminated and we get to see the core profit generating ability of the business.
This formula, however does not give you an estimate of the intrinsic value of the company.
Enter the Earnings Power Value, or EPV.
Earnings Power Value (EPV) Estimates the Intrinsic Value
Discounted cash flow analysis is used to estimate the present value of a series of future cash flows. This is a mathematical equation and not subject to alternative interpretation.
NPV = CF(0) + CF(1)/(1+R) + CF(2)/(1+R)2 + … + CF(n)/(1+R)n
The above equation calculates NPV for a series of cash flows over the period n, with a rate of discount = R per period.
The dividend discount model is a special case of NPV calculation that assumes the dividends paid out to the investor is the only thing that matters to the investor, and therefore the investor values the share based on the DCF of the dividend payments.
However, the problem is that business operations do have a continuing value even after all the dividends are paid.
Alternative dcf calculations may use the EPS as the cash flow and the risk free rate as the discount rate. This is certainly better. However it does have the accounting noise of the fluctuating tax rates and changing capital structure. For EPV calculation, we use the normalized earnings as the numerator and the company cost of capital (WACC) as the denominator.
EPV = Normalized Earnings/WACC
This assumes that the Earnings and WACC stay constant in the future. Therefore the NPV equation simplifies into the Present Value of a constant perpetuity.
How is the Normalized Earnings Calculated?
To calculate the normalized earnings, one takes an average of the Operating Margins for the last 5 years, and then multiplies it to the Revenue for the current year.
Therefore, Normalized EBIT = Average Operating Margin (5yrs) * Revenue (Current year)
Thereafter, Normalized Earnings = Normalized EBIT * (1-tax rate)
Further adjustments for excess depreciation, one off events, etc can be done to the Normalized Earnings number.
Where Does Earnings Power Value Fit in the Spectrum of Valuation Models?
Generally, balance sheet based valuation methods such as liquidation value gives the most conservative intrinsic value for the business. Using future earnings estimates, or growth rates to get the intrinsic value is one of the most optimistic methods. As you may have divined by now, using the present day earnings and cost of capital and a no-growth method such as Earnings Power Value typically gives us an intrinsic value somewhere in between the Balance Sheet based intrinsic value and Earnings growth based intrinsic value.
Deeply conservative value investors may want to stick to the balance sheet based valuation models. Growth investors typically swing to the other extreme.
Why do We Need Earnings Power Value?
This is the key question.
The nature of the business has changed considerably since Ben Graham plied his trade. The current economy is heavily weighted towards asset light businesses. A balance sheet approach works best when there are tangible assets on the balance sheet. Tangible assets require investment and can act as barriers to entry for new players. For service based industries with very little tangible assets, a balance sheet approach to valuation will severely undervalue the profit generating capacity of the business.
Put it another way, traditional valuation techniques miss many undervalued companies that can be caught by the Earnings Power Value technique.
Value investors have typically addressed this with many kludges. For example, there can be different benchmark Return on Asset values based on the industry or sector. Other multiples may be normal in one industry but the same value can represent gross over valuation or under valuation in a different industry.
When you use a construct such as Earnings Power Value, this kind of kludge is not needed. It is a framework that brings some sort of elegance to the practice.
NOTE: If you use Stock Rover, the fair value calculation closely approximates the EPV
– Columbia University Lecture Notes on Earnings Power Value, Bruce Greenwald, (downloadable pdf)
– Value Investing: From Graham to Buffett and Beyond, Bruce Greenwald