Valuation Technique - Earning Power Value (EPV)

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  • 8/8/2019 Valuation Technique - Earning Power Value (EPV)


    D E C E M B E R 2 8 , 2 0 0 7

    Valuation Technique: Earning Power Value (EPV)

    I have discussed in aprevious post the discounted free cash flow valuation

    method. Another technique I use and prefer is the Earning Power Value andreproductive asset value (EPV). The reasons why I prefer this technique are manyamong them:

    1. It ignores growth and future projections of sales. Growth projections arealways faulty and if they materialize it is by sheer luck.

    2. Discounted cash flow models ignore the balance sheet and this oneincorporate it as part of the valuation.

    3. This method is more conservative.4. It gives me an indication if management is able to exploit effectively its

    assets and competitive advantages.

    In the following I will give an overview step by step guide to conducting thevaluation. Valuation is conducted in two separate steps:

    1. Estimation of asset reproductive value2. Determination of EPV

    1. Asset Reproductive Value

    Asset reproductive value is the cost of assets needed by a new entrant to competein an equal manner with an incumbent in the industry. This step can be very

    involved and need some industry and company insight. You need the company'smost recent balance sheet to begin. Valuation will be easiest for current asset andliabilities in general, however more involved with the fixed assets portion of thebalance sheet.

    You start withbook values of the balance sheet, generally it iseasiertovalue the topitems andit getsharder as you godown the account list. In the following I will present atable witheachmajorcategory of assets and the neededadjustment tobe made toarrive at areproductive asset value.

    Account Adjustment

    Cash and Generally there is no adjustment needed as cash is cash
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    and marketable securities are marked to market andrepresent fair value


    receivables (AR)

    the reproduction cost is greater than the book valuegenerally, as companies write off bad debt and apply

    doubtful debt allowance to AR. At a minimum you add theallowance of bad debt to book value of AR as any newentrant will experience defaults and such expenses.


    In a liquidation scenario it is valued at zero but at anoperating level you have to value it at FIFO basis. If the

    firm is valuing it using LIFO then add the LIFO reserve backto the balance sheet number to arrive to reproduction


    Deferredtax assets

    PV of cash savings if the company is anticipating to usethem if the company is in no position to use these assets

    then value them at zero.

    Building &Land

    Generally this item will never be replaced at less thanoriginal cost. If the land and buildings are a critical then

    you have to asses the market value and it is usuallyupwards as land are booked on the balance sheet in

    historical terms and undervalues current market values.For example retailers like Home Depot and Sears havepurchased all their location years ago therefore their

    balance sheet value understates the true economic costfor a new competitor that want to compete against them.

    To get proper value you need to apply similar transactionvalues to the company's buildings and land on a locationby location basis. This can be one of the hardest steps in

    the process and the more research intensive.

    Plants &


    In general there is a long term trend of equipmentefficiency and advancement so historical value of plantsand equipment may be higher than what a new entrantinto the industry might have to pay. Here a familiarity of

    the industry production method and technologies will help.

    On going plants use the price for unit production capacityvalue. What is the market value or production price perunit of output for other comparable companies. Example,what is the price of tonnage of aluminum in the market

    multiplied by how many tonnage does the plant producegives a reproductive value for the aluminum plant.

    Intangibles 1. How many years in R&D spending to reproduce aproduct? Depends on the industry, in consumer it

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    takes 3 years, in car business it takes 6 years.

    2. Brands: what is the cost to reproduce the brand?

    What is the comparable acquisition price of brands inthe same industry? The acquisition price of some

    deals per each dollar of sales of the acquired brandand apply that multiple to the company sales you are

    valuing. Or simply 3 years of marketing and sales

    expenditure of the firm



    PV of cash to be paid in the future if the company isprofitable. But if it is anticipated to generate losses thenyou have to push payment into the future further and will

    be valued less.


    Book value is a good reproductive value for this accountand no adjustment is needed.

    Long termliabilities

    Market value of debt as a new entrant will have to issuedebt at current interest rates which may be different than

    the historical prices of the company debt. You can lookthese up using yahoo finance.

    Please note that if you are attempting this valuation on a viable industry then it isreproductive valuation. However if the industry is not viable then liquidationvalues should apply, in other words serious discounts should be applied to theassets.2. Earning Power Value

    Earning power value: is the second aspect of the valuation of abusiness. Basically EPV is...A business's ability to generate profit from conducting its operations. Earningspower is used to analyze stocks to assess whether the underlying company isworthy of investment. Possessing greater long-term earnings power is oneindication that a stock may be a good investment.or in a mathematical equation EPV= Adjusted Earrings/ cost of capital

    The calculation assumes no growth and current earning is sustainableover the long run. This is one of the great advantages of the technique

    as it does not muddy the valuation process with future predictions. It

    evaluate a company based on its current situation. However to arrive

    at EPV there are several adjustments to be made to the Earningsfigure as follows:

    1. Operating earning or EBT is the start point.

    2. You need to adjust EBT for the business cycle and cyclicallity by

    taking a 7 year Average of operating earning, which will includeat least one economic downturn. You can do this by averaging

    the company's EBT margin over 7 years and apply it to current

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    year's sales, and viola it will adjust for cyclicallity and businesscycle.

    3. Next deduct the 7 year average of non-recurring charges ornormalize these expenses to reflect their economic nature. Non

    recurring charges are part of doing business and they will arise

    in the future so I do not see why you need to exclude them.4. Apply Tax rate the figure derived in step 3, which is the average

    tax rate of the company over the last 7 years. Alternatively usethe general 33% corporate tax rate to avoid tax schemes

    implemented by different companies.

    5. Add depreciation of the most recent year.6. Next deduct adjusted Depreciation: true depreciation is the cost

    to the company to make it at the end of the year in the samesituation at the beginning of the year. Accounting depreciation is

    irrelevant as it can be higher because capital goods prices go

    down due to technology advancement, or it can be lower ininflationary environment where reproduction costs is higher then

    accounting depreciation underestimates true economic cost, soyou have to adjust for it by using maintenance capital expenses

    (CAPEX) as the true measure of depreciation. You can calculatemaintenance CAPEX by:

    Calculate the Average Gross Property Plant and

    Equipment (PPE)/ sales ratio over 7 years Calculate current year's increase in sales Multiply PPE/Sales ratio by increase in sales to arriveto growth capex

    Maintenance CAPEX is the Capex figure from thecash flow statement less growth capex calculated above,which is the true depreciation for the company

    7. Cost of capital estimation: estimate by judgment or usecompany cost of capital as discussed in my earlier post here.

    8. Divide the adjusted earnings calculated in step 6 by cost of

    capital in step 7 to get EPV.

    The final step is to compare the per share reproductive asset value in

    step 1 (Assets-liabilities/ # of shares) to EPV per share calculated in

    step 2 and you got a value of the business. Companies withsustainable competitive advantage should have a higher EPV than

    asset value and the difference is the franchise value. If the reverse istrue management is destroying shareholder's value by earning less

    that the assets capability and you can conclude that the business is acommodity business with no attractive ROIC profile.If yourequire more detailson this technique, Irecommendbuying Bruce Greenwald's book: Value Investing: from Graham toBuffett and Beyond. I alsorecommend watching the followinglecture by Prof Greenwald about the subject, youcan viewit here.I hope the above helps.

  • 8/8/2019 Valuation Technique - Earning Power Value (EPV)


    Sources: Value Investing: from Graham to Buffett and Beyond byBruce Greenwald, Security Analysis by Graham and Dodd,