What is Earnings Power Value?
Earnings power value is a method of valuing the stocks of a company, assuming that the current earnings are sustainable, and there is no future growth.
It means that earnings power value assesses the stocks’ value of a company with an assumption that it will continue to earn constant profits over the years but with zero growth in the profits.
A company can achieve sustained profit levels by making sure that just adequate capital is invested back into the company’s operations. The earnings power value method considers only the maintenance CAPEX, which is required to sustain the existing profit levels.
- Earnings power value is a method used to find out the intrinsic value of a company’s stock, assuming constant profits and no future growth.
- Earnings power value per share may be compared with the market price of the company’s stock to determine if the stock is overvalued, undervalued, or fair valued.
- Earnings power value uses the company’s earnings, available on the financial reports of the company, to determine a company’s stock value.
Earnings Power Value Calculation
The earnings power value is calculated through the following steps:
Step 1: Compute average Earnings Before Interest and Tax (EBIT) margin.
The EBIT margins of the past five years (instead of one year) are considered, as the company earnings are high in some years and low in some years. Hence, the average EBIT margin for a comprehensive business cycle is considered.
The business cycle of five years is sufficient to include high, moderate, and low margins of a business.
Step 2: Normalize the EBIT and calculate after-tax earnings.
The normalized earnings represent the earning capacity of the company that an investor can expect in the future.
Normalized EBIT = Current Sales * Average EBIT margin
After Tax Normalized EBIT = Normalized EBIT * (1 – Effective Tax Rate)
Step 3: Add depreciation.
Normalized profit = After Tax Normalized EBIT + Adjusted Depreciation
Adjusted Depreciation = (0.5 * Effective Tax Rate) X Average Depreciation (5 years)
Step 4: Calculate Average Maintenance CAPEX.
Maintenance Capex = Total Capex X (1 – % Income Growth Rate)
Average Maintenance Capex = Average of Maintenance Capex in the last 5 years
Step 5: Compute Gross Earnings Power Value.
Adjusted Earnings = Normalized Profit – Average Maintenance Capex
Gross Earnings Power Value = Adjusted Earnings / WACC
Step 6: Compute Earnings Power Value.
Earnings Power Value = Gross Earnings Power Value + Excess Net Assets – Debt
Earnings Power Value per Share = Earnings Power Value/ Number of Shares Outstanding
Interpretation of Earnings Power Value
The earnings power value is used to determine whether a company’s stock is overvalued, undervalued, or fairly valued.
- A company’s stock is undervalued if the earnings power value per share of its stock is higher than the current market price of the stock.
- If the earnings power value per share is lower than the existing market price, the company’s stock is overvalued.
- A company’s stock is fairly valued if the earnings power value per share of the stock equals its current market value.
Since earnings power value considers only the current profit levels of the companies, the growth stocks will be valued for much less. Furthermore, if a company is not able to maintain the current level of earnings in the future, the earnings power value method will overestimate the company’s intrinsic value.
Earnings Power Value vs. Discounted Cash Flow
The discounted cash flow (DCF) approach of valuation assumes a growth rate to estimate a company’s future cash flows. However, different analysts may assume different growth rates; thus, the company value calculated using the DCF method varies widely.
Conversely, the earnings power value approach does not require any such assumptions and hence eliminates any speculation work. It uses numbers directly from the company’s financial statements for calculating the intrinsic value of the company.
The earnings power value approach depends on the company’s ability to maintain constant profits. Therefore, the method helps to overcome the challenges associated with the assumptions of profit margins, future growth, and cost of capital. However, the earnings power value method does not consider any variations affecting business operations.
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