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The Power of Earnings

Ron Gross and Andy Cross
August 9, 2010

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