What Is Earnings Power Value (EPV)?
Earnings power value (EPV) is a technique for valuing stocks by making assumptions about the sustainability of current earnings and the cost of capital but not future growth. Earnings power value (EPV) is derived by dividing a company's adjusted earnings by its weighted average cost of capital (WACC).
While the formula is simple, there are a number of steps that need to be taken to calculate adjusted earnings and WACC. The final result is "EPV equity," which can be compared to market capitalization.
The Formula for EPV Is
EPV=WACCAdjusted earningswhere:EPV=earnings power valueWACC=weighted average cost of capital
- EPV ignores some important financial aspects, such as future growth and competitor assets.
- EPV is derived by dividing a company's adjusted earnings by its weighted average cost of capital.
- EPV equity can be compared to the current market capitalization of the company to determine whether the stock is fairly valued, overvalued, or undervalued.
How to Calculate Earnings Power Value (EPV)
EPV starts with operating earnings, or EBIT (earnings before interest and tax), not adjusted at this point for one-time charges. Average EBIT margins over a business cycle of at least five years are multiplied by sustainable revenues to yield "normalized EBIT." (Greenwald considers "sustainable" as "usually current" revenues.) Normalized EBIT is then multiplied by (1 - average tax rate). The next step is to add back excess depreciation (after-tax basis at one-half average tax rate).
At this point, the analyst has a firm's "normalized" earnings figure. Adjustments now take place to account for unconsolidated subsidiaries, current restructuring charges, pricing power, and other material items. This adjusted earnings figure is then divided by the firm's weighted average cost of capital (WACC) to derive EPV business operations.
EPV is meant to be a representation of the current free cash flow capacity of the firm discounted at its cost of capital.
The final step to calculate the equity value of the firm is to add "excess net assets" (mainly cash plus the market value of real estate minus legacy costs) to EPV business operations and subtract the value of the firm's debt. EPV equity can then be compared to the current market capitalization of the company to determine whether the stock is fairly valued, overvalued, or undervalued.
What Does Earnings Power Value Tell You?
Earnings power value (EPV) is an analytical metric used to determine if a company's shares are over- or under-valued. It was developed by Columbia University Professor Bruce Greenwald, a renowned value investor who, through this valuation technique, tries to overcome the main challenge in discounted cash flow (DCF) analysis related to making assumptions about future growth, cost of capital, profit margins, and required investments.
Limitations of Earnings Power Value
Earnings power value is based on the idea the conditions surrounding business operations remain constant and in an ideal state. It does not account for any fluctuations, either internally or externally, that may affect the rate of production in any way.
These risks can stem from changes within the particular market in which the company operates, changes in associated regulatory requirements, or other unforeseen events that affect the flow of business in either a positive or negative way.