Value any Stock

To determine sustainable earnings, it is necessary first to determine a sustainable sales level. This may be the most recent annual sales or an average of, say, the last three years' sales if this year was unusual, or potentially even forecast sales (although this arguably violates the no-growth condition). To be prudent, we take an average of all three, if available.

To normalise margins and eliminate the effects on profitability of valuing the firm at different points in the business cycle, it is usually best to take a long-term average of operating margins. Ideally this would be as long as 10 years and include at least one economic downturn but 5-7 years may suffice. To smooth out unusual years but reflect recent developments, we take an average of the 5 year margin and the TTM margin.

The next step is to deduct the long term average of non-recurring charges (or normalize them to reflect their true economic nature) to strip out the distortive effect of those companies that mis-classify ongoing business expenses as exceptionals.

EPV analysis recognises that part of SG&A expenditure is made to maintain and replace the existing assets, while part is made to grow sales. Since EPV is only interested in what it costs a going concern to maintain its existing asset base, it adds back a percentage of SG&A (between 15% and 50% - this is a matter of judgment and industry knowledge) to make up for the fact that some of this expenditure went to fund growth and shouldn't be accounted for. To start off, we assume 15% for the sake of prudence.

As accounting depreciation may not reflect the true economic cost, EPV adds it back, after-tax, and deducts maintenance capex instead. Maintenance capex can be calculated by deducting growth capex from total capex. Growth capex can in turn be calculated by multiplying the long-term average Gross PPE / sales ratio by the current year's increase in sales. Where this exceeds total capex, maintenance capex is assumed to be zero.

The Discount Rate can be thought of as the interest rate demanded for taking on the risk of owning the stock. The lower the discount rate, the more confidence shown in future cashflows. While theoretically it is possible to use Beta to estimate the discount rate, growing empirical evidence suggest that this is a fundamentally flawed approach. Instead, as a general rule of thumb, blue chip discount rates might be up to 9-10%, Mid Caps 11-12% and small caps or volatile stocks 13-15%+.