The Power of Earnings

Cold, hard cash flow. We talk about it a lot here at The Motley Fool. One method we've found to be very useful in determining the value of a company's current cash flow is earnings power value, or EPV. In contrast to valuation methods that require making uncertain growth projections, EPV is based only on a company's actual (trailing 12 months) cash flow. We can actually ignore growth estimates when using this tool, so this makes it a great starting point for analyzing a stock. Once you get comfortable with the formula, we think you'll find that it's a great method for determining what a company's current cash flow is worth.

EPV is useful because it can be calculated quickly using just a few data points. Stripped down, EPV is simply current adjusted cash flow, divided by the company's cost of capital, plus cash minus debt. And because EPV allows us to ignore future growth, another selling point is that it serves as a conservative measure of valuation.

EPV and Y-O-U
While this formula may look a bit long, it really is quite simple to use once you get the hang of it. Once you crunch the numbers, the result is an estimate of a company's value, assuming no growth. And finding the data isn't so difficult. Start by typing a company's ticker into the Fool's search box and clicking on the "Statements" tab under the company's name. Our starting point is always earnings before interest, taxes, depreciation, and amortization (EBITDA).

EPV formula

Operating income before depreciation and amortization (EBITDA)

- Depreciation and amortization

- Income taxes
= Net operating profit after taxes (NOPAT)
+ Depreciation and amortization
- Maintenance capital expenditures (only capital spending used to maintain the business, no growth)
= Adjusted EBIT

Now divide this amount by the cost of capital (so if the cost of capital is 10%, then divide by .10) to get:
Capitalized EBIT
+ Cash
- Total debt
= Earnings power value
/ (Divided by) shares outstanding
= EPV per share

We use a few simplifying assumptions to make this formula a little easier to work with. For example, we assume maintenance capital expenditures are equal to 25% of total capital expenditures. Also, we use a standard 10% as a cost-of-capital estimate. Of course, you can always do a little more work and dig a little deeper if you want more accurate inputs.

What does it mean?
To illustrate how you can apply EPV, let's use a fictitious company called RJG Company (Ticker: RJGC). If you crunch the numbers, let's assume that RJG's EPV comes out to be $40 per share, while the stock trades for about $36. What does that mean? It means that if RJG's current cash flow stayed the same forever, the company's intrinsic value would be $40 per share. So RJG is not only selling at a discount to the value of its current earnings, but if you buy the stock today, you'll be getting all the future growth for free!

The next step is figuring out if you believe RJG's cash flow will grow -- and if so, how much that future growth is worth. Typically, this is where a discounted cash flow analysis comes in handy.

Let's look at another made-up example using Cross Industries (Ticker: XIND). Cross has an EPV of $18 per share, yet its stock price is $25. What this tells us is that at current prices, you're paying about $7 per share for all of Cross's future growth. You can now use that knowledge to determine if you think that $7 is a reasonable price to pay for Cross's growth prospects.

Dig deeper
Now before you get too excited, remember that we said the EPV should be a starting point, not an end. Part of an investor's job is to figure out why a stock like RJG might be so cheap or why paying $7 per share for a growth company like Cross might be a steal. Some reasons should jump right out at you -- for instance, that investors don't believe RJG's recent earnings are sustainable.

A few final EPV thoughts:

  • In normal markets, it's difficult to find a company that's selling for less than its EPV. Why? Future growth is a significant part of a company's overall value. However, EPV is still valuable because it will tell you how much you're paying for future growth, and you can then decide if you're comfortable with that.
  • If current earnings aren't sustainable, you'll get an EPV that is too high.
  • If current earnings are unusually high, you might want to use a more normalized number by taking a discount to recent earnings or a three- or five-year average.

We hope this gives you some insight into one method to value companies -- maybe it has even sparked an interest to learn more about EPV. For more information, we highly recommend Columbia University professor Bruce Greenwald's book Value Investing: From Graham to Buffett and Beyond. Greenwald takes EPV one step further and spends a fair amount of time discussing how useful it is to compare the EPV with the result you get from undertaking an analysis of the balance sheet in order to derive an adjusted net asset value (or book value). This comparison can give you some insight into whether management is creating or destroying shareholder value through the use of its assets. But, that's a primer for another time. Fool on!

Ron Gross is the lead advisor of the Fool's Million Dollar Portfolio service. Andy Cross is co-advisor of Motley Fool Hidden Gems and an associate advisor for Motley Fool Stock Advisor.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 10, 2010, at 5:50 AM, ewolo wrote:

    These types of articles are great. Recently I have noticed a lot more research and process-based articles, like this one, the Small-Cap Report Card and Dividend Report Card.

    I like these articles because it sheds some light on what you guys look for in companies and gives us some more tools that we can use in our own research on company ideas we get from this community, as well as others we come across elsewhere.

    One of the missions of the Fool is to educate. I think that these series of articles are a great way to educate the individual investor as they are usually presented in easy-to-understand ways, as opposed to an investment book that you pick up at the bookstore.

    Anyways, I like this new initiative of articles and look forward to reading some more articles like this.

    Thanks and keep up the good work.

  • Report this Comment On August 10, 2010, at 5:52 AM, ewolo wrote:

    oh ... and also the 'series' part about these articles really makes it come together. Having some real examples on companies with current information really adds to the learning, as opposed to learning the process and then trying to go out and use it on our own.

  • Report this Comment On October 10, 2012, at 10:37 AM, OldSchoolValue wrote:

    For a much more indepth and step by step tutorial you can follow, here is an article I wrote.

    http://www.oldschoolvalue.com/blog/valuation-methods/stock-a...

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