Earnings Power Value

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Earnings Power Value (EPV) is a valuation tool that was popularized by Bruce Greenwald, et al, in the book Value Investing: From Graham to Buffett and Beyond.

Expanded Definition
The basic concept of EPV is that one should value a stock based on the current free cash flow of a company and not on future projections which may, or may not, come true. This valuation tool excludes the potential growth that a company may have so that needs to be looked at separately. Since future growth is excluded from the analysis, only the maintenance capital expenditures are subtracted from after-tax EBIT (earnings before interest and taxes) and growth capex is ignored. The general EPV formula is: After-tax EBIT + Depreciation and Amortization - Maintenance Capital Expenditures This result is then divided by a company's weighted average cost of capital (WACC) to derive the Earnings Power Value. Now all that needs to be done is to add the company's cash balance, subtract the company's total debt and divide by the number of shares outstanding. This will yield the company's theoretical Value/share. But don't forget it excludes the benefits of future growth so it typically will yield a very conservative estimate of a stock's value.

Earnings Power Value

Earnings Power Value is an estimate of the value of a company from its ongoing operations. The beauty of Earnings Power Value, for value investors, is that the numbers used to calculate it are no growth free cash flows. No growth free cash flows just mean that we are only subtracting from cash flows the amount of capital expenditure required to sustain the business. By using no growth free cash flows we eliminate, to a great degree, attempts to predict future growth and as such arrive at a number which we can be fairly certain of; we are using today's earnings, with the assumption that current profitability is sustainable. This isn't to say that some companies can't expect significant growth, but as value investors we refuse to pay for it. Though we are using today's earnings (today's no growth free cash flows) in calculating Earnings Power Value, we are normalizing these earnings to the business cycle. This eliminates the effects on profitability of valuing the firm at different points in the business cycle. Ideally, this means that we are considering the average operating profit (as a percentage of total sales) over 5-8 years. This average would then be applied to current sales. Other adjustments to be made to the current year's cash flows would be to account for average expected one-time gains/losses. The final step in calculating Earnings Power Value is to divide the final cash flow number by the cost of capital. This gives us the present value of a perpetuity without any estimation of growth. That is the Earnings Power Value.