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 a specific formula: Adjusted Earnings / Cost of Capital. While the formula is simple, there are a number of steps that need to be taken to calculate adjusted earnings. The final result is "EPV equity," which can be compared to market capitalization.
BREAKING DOWN Earnings Power Value - EPV
Earnings power value (EPV) was developed by Columbia University Professor Bruce Greenwald, renown 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. EPV is meant to be a representation of current free cash flow capacity of the firm discounted at its cost of capital.
Earnings Power Value Steps
EPV starts with operating earnings, or EBIT, 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 (Greenwald considers "sustainable" as "usually current" revenues) to yield "normalized EBIT." 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. The final step to calculate equity value of the firm is to add "excess net assets" (mainly cash plus the market value of real estate less 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.