“Use knowledge to reduce uncertainty” – Bruce Greenwald
As presented at the Vancouver Value Investors Club on June 28, 2012.
The first thing one must understand about a conventional valuation method based on a company’s earnings is that it is seldom applicable. What is meant by this, is that any business which does not possess any inherent competitive advantages over others in its industry should be valued strictly based upon its assets and the liquidation or reproduction value of such.
In the rather rare instance in which a business does possess some competitive advantage or “franchise value” only then should an earnings test be applied to determine if the business in question does indeed possess any earnings power from its perceived competitive advantages.
The study of what entails a competitive advantage is beyond the scope of this brief tutorial, for that i refer you to Bruce Greenwald’s excellent work Competition Demystified penned in 2007, which follows up and elaborates on Michael E. Porter’s great 1980 book Competitive Strategy.
While there are other ways to value a business based upon its earnings, namely by performing a discounted cash flow analysis (DCF) i believe the EPV method, which is firmly grounded upon a company’s past and historical earnings does away with much of the guesswork involved in making future earnings and cost of capital estimates which even the most intelligent investors have shown an inherent inability to do.
Further, the EPV method implores objectivity as it is entirely grounded upon current information and fundamental competitive conditions, rather than obfuscation of good information by lumping it together with predictions about events that are a long way in the future (mixing correct data with incorrect data results in incorrect data)
Of course, such valuation methods as the one we are discussing require some specialized knowledge about particular industries and assets as well as the ability to shun rosy projections of the future. But this is the discipline of investing over intelligent or unintelligent speculation.
Our tutorial begins with Company A’s Income Statement:
In this sense, this exercise is very similar to our Reproduction Value study, which precedes an EPV calculation and begins by adjusting a company’s balance sheet rather than its income statement.
The first thing we must do upon scanning the income statement is to add back any one time charges (which may be listed under the heading Other Costs and Expenses). This is done because, just as the name suggests they are non-recurring and unique to any one single year.
Our second step is to normalize earnings by taking a snapshot of the past 5-10 years of a company’s earnings and using a median from this time frame. This way we bypass any overly good or bad year as well as the business cycle. Here is our Company A example:
Our avg. earnings for Company A’s most recent five year period is $15,287.6.
Next, we must add back excess depreciation. What would qualify as excess depreciation? Unlike in a classroom there is no single right answer, the more familiar one is with the particular business and industry in question the more accurately they will be able to assess the PP&E (Property, Plant & Equipment) account and how fast it loses value.
Once this is done, we must also take into account other extraordinary one time items such as earnings or losses from unconsolidated investments (non-controlling interests), interest paid or earned and the like. Again, we want to take the median “extraordinary items” for the past 5-10 years and either add or subtract them from the earnings (depending upon the investor’s personal view) before arriving at our “normalized earnings” figure.
Maintenance Capital Expenditures
Next, we subtract maintenance capital expenditures (which is properly defined as the capital a company needs to re-invest back into the business to keep it operating as a going concern). This will differ on a case by case basis, with industries such as manufacturing and distribution requiring much more CAPEX than service based firms.
This is done from Company A’s Cash Flow Statement:
To be conservative we can take a five year composite of a company’s CAPEX as well, Company A’s comes out to an avg. of: $12,979.8 which must be re-invested back into the business in a typical year.
Lastly, we must add back any surplus cash left on the company’s books after deducting debt (should any be left over) Once this is done our final EPV calculation looks like this:
Normalized Income – Capital Expenditures / Weighted Average Cost of Capital (WACC)* = Earnings Power Value
*Average cost of funds for the company.
Thus we see that by applying an EPV analysis we are making no forecasts of possible future earnings or predictions about future growth which may, or as is often times the case may not occur. We are merely extrapolating current earnings and assuming that they are sustainable (hence our conservatism in utilizing “median” earnings so as to exclude any overly prosperous or disastrous years).
Additionally when we compare a company’s reproduction value to its earnings power value we begin to get a very clear idea of its competitive advantages and if it truly does or doesn’t possess any.
To sum up, as intelligent investors we do not want to overpay for growth or even for existing operations if possible. We also want to determine an approximate value for our company without relying too heavily upon highly sensitive assumptions, which in the end are simply unreliable.
Further, any mechanism which will enable us to systematically not overpay for a business will be welcome, which is precisely what the EPV method allows us in relation to earnings analysis.
– Value Investing: From Graham To Buffett & Beyond By Bruce C.N. Greenwald, Judd Kahn, Paul Sonkin & Michael van Biema
– Earnings Power Value Lecture By Bruce C.N. Greenwald
– How To Value a Stock With Earnings Power Value By Jae Jun