EPV equity can be compared to the current market capitalization of the company to determine whether the stock is fairly valued, overvalued, or undervalued. Normalized EBIT is then multiplied by 1 - average tax rate. The next step is to add back excess depreciation after-tax basis at one-half average tax rate. Adjustments now take place to account for unconsolidated subsidiaries, current restructuring charges, pricing power, and other material items. EPV is meant to be a representation of the current free cash flow capacity of the firm discounted at its cost of capital.
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Microsoft MSFT will serve as a fine example since you know the history of the company and what it does. Earnings Power Value Technique The valuation technique of earnings power value requires the investor to consider 3 things.
The value of assets a competitor will be required to have in order to achieve the same market value of the incumbent company in the industry. Earnings power value calculated based on current financial status where the resulting intrinsic value ignores business cycles.
Whether growth is a factor. Reproducing the Assets of Microsoft In respect to no. Applying this idea to Microsoft, the first step is to adjust the balance sheet. We are trying to get to a figure that a competitor will have to realistically pay up in order to enter the market. Step two. Some companies will spend very little for both aspects and it can be ignored but to ignore for MSFT would be a mistake. Something else to remember is that although off balance sheet liabilities are liabilities, a significant part of that will also have to be reproduced by a new entrant in order to start business.
VVTV may be just another home shopping company but for a new competitor to enter the market, they will have to spend money on carriage licenses and other network equipment and licenses that will sometimes not appear on the balance sheet.
It may be a liability when valuing the business as a standalone, but when considering what a competitor will have to pay, it should be included. The final step to calculate the net reproduction cost is to subtract non interest bearing debt and the cash not required to run the business.
Non interest bearing debt is really spontaneous liabilities. The concept is very similar. Start off with EBIT, and start working through items and decide whether to add it back or ignore it.
Start off with operating earnings, i. Find out if there are any one time charges and add it back. Third step is to apply a tax rate to the adjusted EBIT.
Which is represented by the Adjusted Earnings After Tax line in the image above. Fourth step you add back in a certain amount of depreciation and amortization. The best thing is to be familiar with the business and industry to accurately assess the equipment needed and how fast it loses value etc.
When you do all those steps, you finally come up with an Income as Adjusted number. What I do, along with all of the other valuation techniques, I smooth out the data by taking multiple year snapshots and then taking the median of these timeframes. This way I come up with a normalized adjusted income to ignore business cycles and the occasional overly bad or good year.
Earnings Power Value Adjusted Income and Growth So with the normalized adjusted income you subtract maintenance capital expenditures and divide by the discount rate. The result is the EPV, which is the value of the company based on current earnings and ignoring growth.
But there is one last step. Lastly, add to the EPV value Cash-debt because operating earnings ignore the interest on cash balances so you have to add the surplus cash to the EPV. What does this mean? Everything is just based off automatic calculations so you could fine tune your results if desired.
Bruce Greenwald’s Earnings Power Value EPV Lecture Slides
But when I went into its calculations, its phenomenally detailed and good. I was really impressed with the person who developed such a concept. Who is Bruce Greenwald? Since , he is working in Columbia Business School as a Professor. This course is only for the Columbia Business School first-year students. So, when a person of the stature of Bruce Greenwald develops a stock valuation model, it must be something out of the box.
Earnings Power Value (EPV) Stock Valuation How-To
Here is how Investopedia describes the EPV model: Earnings Power Value EPV is a technique for valuing stocks by making an assumption about the sustainability of current earnings and the cost of capital but assuming no further growth. As Investopedia suggests, calculating adjusted earnings is part art, part science. The models on finbox. Here is a look at the buildup: By default, finbox.
Earning Power Value (EPV) Method of Stock Valuation
Multiple methods based on industry and competitors used occasionally Disadvantages of Stock Valuation Methods Discounted Cash Flow Need to estimate a growth rate. Be conservative Need to project into the future Does not work well for young, growth or cyclical businesses Ben Graham Formula Uses earnings which can always be inflated even if it is normalized Projects using a EPS growth rate Back tests have shown that the value is the upper range and overly optimistic Ben Graham Net Net Formula Calculates the value of assets only Does not provide an upper range indicator A snapshot valuation method Multiples Valuation Useless if business has no direct competitors e. Mead Johnson Nutritionals. The stock valuation method allows the investor to value all of the above points.
Earnings Power Value (EPV)