Earnings Power Value also known as just Earnings Power is a valuation technique popularised by Bruce Greenwald, an authority on value investing at Columbia University. It is arguably a better way to analyze stocks than Discounted Cash Flow analysis that relies on highly speculative growth assumptions many years into the future.
EPV uses a very basic equation which assumes no growth, although it does rely on an assumption about the cost of capital as well as the fact that current earnings are sustainable. It also involves several adjustments to clean up the underlying Earnings figures.
How does EPV work?
The EPV equation is Adjusted Earnings divided by the company's Cost of Capital. This is calculated as follows:
1) Cyclically Adjusted Operating Earnings: The starting point is Operating Earnings, i.e. EBIT. However, this may need to be normalised to eliminate the effects on profitability of valuing the firm at different points in the business cycle. This is done by taking a long term (say, 5-7 years) average of operating earnings, ideally this would be as long as 10 years and including at least one economic downturn.
2) Normalising for non-recurring charges: The next step is to deduct the long term average of non-recurring charges (or normalize them to reflect their true economic nature) to determine the adjusted and cyclically normalised Operating Earnings.
3) Normalised Taxation Adjustment: To this figure, we apply a normalised tax rate – this could either be the average tax rate of the company over, say, the last 5-7 years or alternatively use the general corporate tax rate to avoid the distortive effect of different tax schemes (in the UK, this has been 28%, although it moved to 26% in April this year).
4) Economic Depreciation Adjustment: This involves adding back the depreciation figure of the most recent year, after-tax, which may not reflects the true economic cost of depreciation (it can be higher because capital goods prices go down due to technology advancement, or it may be lower in inflationary environment where reproduction costs is higher then accounting depreciation). Economic depreciation is the cost to the company to make it at the end of the year in the same situation at the beginning of the year, i.e. maintenance capital expenditure. This can be calculated by deducting growth capex from the capex figure in the cash flow statement. Growth capex can in turn be calculated…
