How to Use Bruce Greenwald's Earnings Power Value (EPV) to Value Mature Companies

Fajasy
Updated: June 7, 2024

Contents

In this article, I will show you how to use Bruce Greenwald's Earnings Power Value (EPV) to value mature, stable businesses with predictable cash flows. This valuation approach focuses on the sustainability of current earnings and the cost of capital, while ignoring future growth prospects. By emphasizing the fundamental earning capacity of a business, EPV provides a conservative estimate of a company's true worth.

This article will explain the Earnings Power Value (EPV) method and its formula, then describe how to calculate and interpret the EPV. It will include a detailed example featuring a real-world company, accompanied by a free Excel template. Lastly, we'll discuss the limitations of EPV and its application considerations.

Earnings Power Value (EPV) Explained

The Earnings Power Value (EPV) concept can be traced back to the teachings of renowned value investors Benjamin Graham and David Dodd. However, it was Bruce Greenwald who popularized this methodology in modern value investing. Greenwald introduced EPV in his 2001 book, "Value Investing: From Graham to Buffett and Beyond," as a way to estimate the fair value of a company based on its current earnings power.

The premise of EPV is straightforward. The company's intrinsic value is based on the sustainability of its current earnings, assuming no future growth. By focusing on present earnings, EPV avoids speculative growth projections that can lead to overvaluation.

This approach is useful for evaluating mature, stable businesses with predictable cash flows. These companies have established market positions and proven records of consistent earnings. They are less likely to experience significant financial fluctuations due to their stable revenue streams and customer bases. This makes their current earnings a reliable indicator of intrinsic value.

EPV Formula

The Earnings Power Value (EPV) formula is shown below:

EPV = Adjusted Earnings / Cost of Capital

where:

  • Adjusted Earnings: Represent the normalized, sustainable earnings of the company.
  • Cost of Capital: Required rate of return for investors, considering the risk-return profile of the investment.

Adjusted earnings, which the EPV model depends heavily on, can be calculated using the following formula:

Adjusted Earnings = Normalized EBIT × (1 - Tax Rate) - Maintenance CapEx + Excess Depreciation

where:

  • Normalized EBIT: Earnings before interest and taxes, adjusted to reflect the company's long-term earnings power.
  • Tax Rate: The company's effective tax rate, calculated as income tax expense dividend by pre-tax income.
  • Maintenance CapEx: The portion of capital expenditures required to maintain the company's current operations.
  • Excess Depreciation: The tax-adjusted difference between reported depreciation and estimated depreciation.

The EPV formula calculates the intrinsic value of a company by dividing its adjusted earnings by the cost of capital. The cost of capital, often represented by the weighted average cost of capital (WACC), is the minimum rate of return that a company must earn on its investments to satisfy its investors, considering the risk involved.

The EPV formula is also similar to the perpetuity value formula, which calculates the present value of a series of equal, infinite cash flows. The perpetuity value formula is expressed as:

Perpetuity Value = Cash Flow / Discount Rate

In the context of EPV, the adjusted earnings represent the sustainable cash flows, and the cost of capital acts as the discount rate. By using this formula, investors can estimate the intrinsic value of a company based on its current earnings power, assuming no future growth.

It's important to note that while the WACC is commonly used as the cost of capital in the EPV formula, it has some inherent flaws. WACC relies on the capital asset pricing model (CAPM) and the concept of beta, which have been criticized for their assumptions and limitations.

Therefore, using your personal required rate of return or an alternative discount rate approach is recommended when calculating EPV. This allows you to account for your individual risk tolerance and investment goals when estimating the intrinsic value of a company.

Earnings Power Value (EPV) Calculation Example

For our real-world Earnings Power Value (EPV) valuation example, we'll use Union Pacific (UNP) as our example. Union Pacific operates one of the largest railroad networks in the United States, providing freight transportation services across numerous sectors, including agricultural products, automotive, and chemicals.

Union Pacific is suitable for an EPV valuation because it has relatively predictable and stable cash flows, derived from long-term contracts and the essential nature of its transportation services. The company's significant infrastructure investment and established market presence also contribute to its stable earnings, making it a great candidate for the EPV.

Calculating the Earnings Power Value (EPV) involves a three-step process:

  1. Adjusting earnings.
  2. Determining the cost of capital.
  3. Calculating and interpreting the EPV.

While the process is broken down into more granular steps below, these three main components form the foundation of the EPV calculation.

Here's the more detailed steps to apply the EPV valuation:

  • Step #1: Estimate an Adjusted EBIT Margin
  • Step #2: Estimate a Normalized EBIT Margin
  • Step #3: Estimate a Normalized Tax Rate and Calculate NOPAT
  • Step #4: Estimate Maintenance Capital Expenditures (CapEx)
  • Step #5: Adjust for Excess Depreciation
  • Step #6: Calculate Adjusted Earnings
  • Step #7: Determine the Cost of Capital
  • Step #8: Calculate and Interpret the EPV

Investors can use the spreadsheet linked below to follow along for the Union Pacific EPV valuation example:

Step #1: Estimate an Adjusted EBIT Margin

The first step in an EPV valuation is to estimate the company's adjusted EBIT margin based on historical adjusted margins over the last 5+ years.

This is necessary because the EPV method seeks to determine the company's sustainable earnings power under normal business conditions, assuming no future growth. By analyzing historical EBIT margins over a longer period, we can smooth out any short-term fluctuations and arrive at a more accurate representation of the company's core profitability.

To complete this step, we'll need to gather financial data from the company's income statement, specifically the company's total revenues and operating income (EBIT), for at least the last five fiscal years (FY). This data can typically be found in the company's 10-K annual reports, which are filed with the Securities and Exchange Commission (SEC).

To begin, here's Union Pacific's income statement with its total revenues and operating income (EBIT) outlined:

| Stablebread
Source: Union Pacific (UNP) 10-K Annual Statement (Income Statement)

Now, we can calculate the EBIT margin for each year by dividing the operating income (EBIT) by the total revenues, as shown in the formula below:

EBIT Margin = EBIT / Total Revenues

For instance, in FY 2023, Union Pacific reported revenues of $24,119M and an operating income of $9,082M. This means its operating margin in FY 2023 was 37.7% ($9,082M / $24,119M).

After calculating the EBIT margin for each year, we'll take the average or median of these margins, depending on which measure we believe is more representative of the company's typical performance.

It's important to note that when calculating the adjusted EBIT margin, investors should also consider excluding any one-time or unusual items that may have impacted the company's earnings in a given year. These items can include restructuring charges, gains or losses from asset sales, or other non-recurring events. By removing these items, we can get a clearer picture of the company's core operating profitability.

For Union Pacific, although some one-time gains/expenses were mentioned in the "Notes to the Financial Statements" section of its 10-K annual report, they did not appear substantial or were not directly specified, so we'll use the numbers as reported.

Here's how Union Pacific's adjusted EBIT margin is calculated in our EPV financial model:

Union Pacific (Unp): Adjusted Ebit Margin
Union Pacific (UNP): Adjusted EBIT Margin

Thus, with both the median and average adjusted EBIT margins at ~40% over the last five years, it's reasonable to assume that Union Pacific will maintain an EBIT margin of 40% under regular business conditions for the foreseeable future.

Step #2: Estimate a Normalized EBIT Margin

Now that we've calculated the company's adjusted EBIT margin over the last 5 years, the next step is to estimate a normalized EBIT margin.

This is an important step in the EPV valuation process because it helps us determine the company's sustainable earnings power under the assumption of no future growth.

To estimate a normalized EBIT margin, we need to add back any expenses that could potentially drive growth, such as research and development (R&D), marketing, and selling, general, and administrative (SG&A) expenses. By adding these expenses back to the adjusted EBIT margin, we can arrive at a higher normalized EBIT margin that reflects the company's earnings power in a zero-growth scenario.

For Union Pacific, as a railroad company, it's important to identify which expenses are related to maintaining current operations and which are related to growth initiatives. This information can be found in the company's 10-K annual report, typically in the "Operating Expenses" section and the "Management's Discussion and Analysis" (MD&A) section.

Here's how Union Pacific describes its operating expenses in its 10-K annual report:

| Stablebread
Source: Union Pacific (UNP) 10-K Annual Statement (Operating Expenses)

Most of these expenses appear to be directly related to maintaining and operating the company's current rail network, rather than investing in future growth initiatives:

  • Compensation and Benefits: Primarily for paying wages and benefits for current employees, necessary for maintaining existing operations.
  • Fuel: Directly tied to operating the current fleet of locomotives and vehicles, essential for maintaining existing service levels.
  • Purchased Services and Materials: Costs for maintaining existing infrastructure, equipment, facilities, and other services necessary for current operations.
  • Depreciation: Represents wear and tear on existing assets, primarily associated with maintaining current infrastructure, despite some potential growth investments.
  • Equipment and Other Rents: Related to leasing and maintaining equipment necessary for current operations.
  • Other: Includes various expenses such as state and local taxes, insurance, and employee travel, primarily supporting current operations rather than investing in future growth.

Based on the descriptions provided, these operating expense line items are not clearly related to growth initiatives. They all appear to be primarily focused on maintaining and operating Union Pacific's existing rail network. Therefore, in the case of Union Pacific, no specific line-item expenses related to growth will be added back to EBIT.

Instead, if we examine the company's average operating expenses relative to revenues over the last five years, it's at ~60%. In other words, Union Pacific has historically spent an average of 60% of its revenue on operating expenses. Based on our earlier observation, it can be assumed that only a portion of this is dedicated to growth operations.

We can therefore make an assumption that it could cut 10% in a no-growth scenario, given Union Pacific's maturity and strong economic moat with its extensive rail network and established market position. This would result in a 6% bump (60% × 10%) in the EBIT margin (from 40% to 46%).

Now, normalized EBIT for Union Pacific can be calculated by multiplying the normalized EBIT figure (46%) by the company's FY 2023 sustainable revenues ($24,119M), as shown below:

Normalized EBIT [UNP; FY 2023] = 46.0% × $24,119M --> $11,089M

Thus, Union Pacific's normalized EBIT in FY 2023 is $11,089M, which serves as the starting point for calculating the company's sustainable earnings power.

Here's the completed EPV financial model for this entire process of calculating a normalized EBIT:

Union Pacific (Unp): Normalized Ebit
Union Pacific (UNP): Normalized EBIT

Note that some investors prefer to multiply the normalized EBIT margin by the trailing twelve months (TTM) or last twelve months (LTM) revenues, which is the sum of the last four quarters of reported revenues, instead of the last fiscal year's revenues. This approach may provide a more up-to-date view of the company's revenue-generating capacity.

Step #3: Estimate a Normalized Tax Rate and Calculate NOPAT

After determining the normalized EBIT, the next step is to calculate the Net Operating Profit After Tax (NOPAT), also known as Earnings Before Interest After Taxes (EBIAT). NOPAT represents the company's operating profit after accounting for taxes but before considering financing costs (interest expenses).

Calculating NOPAT is necessary because it provides a clearer picture of the company's profitability from its core operations, independent of its capital structure. This is particularly important for the EPV valuation, as it focuses on the company's sustainable earnings power.

To calculate NOPAT, we need to estimate a normalized tax rate. The normalized tax rate should reflect the company's expected long-term tax rate, considering any changes in tax laws, the company's geographic mix of earnings, and other factors that may impact its tax liabilities.

The NOPAT formula is as follows:

NOPAT = Normalized EBIT × (1 - Normalized Effective Tax Rate)

To estimate the normalized tax rate, we can use one of the following approaches:

  • Use the company's effective tax rate, which can be found in its income statement or tax footnote in the 10-K annual report. The effective tax rate is calculated by dividing the company's income tax expense by its pre-tax income.
  • If the company's effective tax rate has been volatile or is expected to change in the future, we can use the statutory tax rate or a blended tax rate that considers the company's geographic mix of earnings and the tax rates in those jurisdictions.
  • If the company has significant deferred tax assets or liabilities, we may need to adjust the tax rate to reflect the expected cash tax rate.

For Union Pacific, we'll use the company's income tax expense and pre-tax income numbers from its income statement to calculate the effective tax rate over the last 5 years. Then, we'll use the average or median figure to normalize the effective tax rate and calculate the company's NOPAT.

Here's Union Pacific's income statement again, this time with its income tax expense and pre-tax income outlined:

| Stablebread
Source: Union Pacific (UNP) 10-K Annual Statement (Income Statement)

With this information, we can calculate the effective tax rate for the company over the last 5 years, as demonstrated in our EPV financial model below:

Union Pacific (Unp): Normalized Nopat
Union Pacific (UNP): Normalized NOPAT

As you can see, Union Pacific's effective tax rate has been relatively stable over the past five years, with an average and median of 23.1%. Therefore, we can use this average effective tax rate as our normalized tax rate for the NOPAT calculation.

Using the normalized EBIT of $11,089M from the previous step and the normalized tax rate of 23.1%, we can calculate Union Pacific's NOPAT as follows:

NOPAT [UNP; FY 2023] = $11,089M × (1 - 0.231) --> $8,529M

Thus, Union Pacific's NOPAT for FY 2023 is $8,529M, which represents the company's after-tax operating profit. This figure will be used in step #6 below, when we calculate the company's adjusted earnings.

Step #4: Estimate Maintenance Capital Expenditures (CapEx)

After calculating the company's NOPAT, the next step in the EPV valuation is to estimate the maintenance capital expenditures (CapEx). Maintenance CapEx represents the investments required to maintain the company's current level of operations and competitive position, as opposed to growth CapEx, which is aimed at expanding the business.

Estimating maintenance CapEx is important because it accounts for the normal wear and tear on a company's assets, such as machines, office space, and property. By subtracting maintenance CapEx from NOPAT, we can determine the company's true cash flow generation potential and arrive at a more accurate measure of its sustainable earnings power.

It's important to note that total PP&E (plant, property, and equipment), as listed under the "Investing Activities" section of the cash flow statement, typically represents the total CapEx figure. This means it includes both maintenance and growth CapEx, as outlined in Union Pacific's cash flow statement below:

| Stablebread
Source: Union Pacific (UNP) 10-K Annual Statement (Cash Flow Statement)

As you can see, Union Pacific spent $3,606M in total CapEx in FY 2023. Typically, a portion of this is maintenance CapEx and the other portion is growth CapEx. It's usually up to the investor to estimate the maintenance CapEx portion...

Estimating maintenance CapEx is a nuanced process that can be accomplished using one of the following approaches:

  • Be conservative, and assume the entire CapEx (PP&E) amount is for maintenance purposes.
  • Analyze the company's CapEx table or detailed description of CapEx components in their 10-K annual report, to infer the maintenance CapEx amount based on the definitions of growth and maintenance CapEx.
  • Estimate a percentage of maintenance or growth CapEx based on your understanding of the business, industry, and management's discussion in the 10-K annual reports.
  • Use the "depreciation and amortization" figure from the most recent 10-K annual report as a proxy for maintenance CapEx, keeping in mind that depreciation can sometimes be an inaccurate representation of the true maintenance CapEx.
  • Apply Bruce Greenwald's maintenance CapEx calculation, but recognize that it may not be suitable for commodity-based businesses or companies with sales growth exceeding PP&E growth.

For Union Pacific, if we look under the "Notes to the Financial Statements" section, there's a table which breaks down the company's total CapEx spend of $3,606M in FY 2023:

| Stablebread
Source: Union Pacific (UNP) 10-K Annual Statement (Investing Activities)

Based on the table and information provided, we can use our understanding of the business to categorize Union Pacific's CapEx into growth and maintenance as follows:

Maintenance Capex:

  • Ties
  • Rail and other track material
  • Ballast
  • Other (bridges and tunnels, signals, other road assets, and road work equipment)

These items are listed under "Total road infrastructure replacements" and are needed for maintaining the company's existing rail network. Replacing ties, rails, ballast, and other track components is likely necessary to ensure the safety and reliability of Union Pacific's operations.

In FY 2023, maintenance CapEx was $1,904M of the total $3,606M (~53% of total CapEx).

Growth Capex:

  • Line expansion and other capacity projects
  • Commercial facilities
  • Locomotives and freight cars
  • Technology and other

These items are related to expanding Union Pacific's capacity, improving its service offerings, and investing in new equipment and technology.

Growth CapEx is the difference between maintenance CapEx and total CapEx, or the sum of the growth CapEx line items. In FY 2023, growth CapEx was $1,702M of the total $3,606M (~47% of total CapEx).

Here's our EPV financial model, detailing the company's total CapEx into maintenance and growth CapEx over the last five years:

Union Pacific (Unp): Maintenance Capex
Union Pacific (UNP): Maintenance CapEx

To be more conservative in our EPV valuation, we'll use Union Pacific's 5-year median maintenance CapEx figure of $1,904M in our final adjusted earnings calculation.

Step #5: Adjust for Excess Depreciation

After estimating the maintenance CapEx, the next step in the EPV valuation is to adjust for excess depreciation.

Adjusting for excess depreciation is important because it helps to account for the non-cash expenses related to the company's capital investments that exceed the maintenance requirements. By calculating the excess depreciation, we can obtain a more accurate representation of the company's sustainable earnings power.

Here's the formula to calculate excess depreciation, as per Bruce Greenwald's approach (see slide 16):

Excess Depreciation = Average Depreciation × (0.5 × Normalized Tax Rate)

This formula adjusts the average depreciation expense for taxes using one-half of the normalized tax rate, as Greenwald suggests that this approach provides a more conservative estimate of the tax benefits associated with the non-cash depreciation expense, essentially assuming that only half of the excess depreciation is tax-deductible.

For Union Pacific, let's calculate the excess depreciation and adjusted earnings using the following figures:

  • 5-Year Average Depreciation: $2,240M
  • Normalized Tax Rate: 23.1%

Here's the excess depreciation calculation for Union Pacific:

Excess Depreciation [UNP; FY 2023] = $2,240M × (0.5 × 0.231) --> $258M

The excess depreciation of $258M represents the portion of Union Pacific's 5-year average depreciation expense that is tax-effected using one-half of the company's normalized tax rate of 23.1%.

Step #6: Calculate Adjusted Earnings

Finally, after calculating the excess depreciation, we can determine the company's adjusted earnings, also known as "normalized" earnings.

To calculate adjusted earnings, we'll complete the following formula:

Adjusted Earnings = NOPAT - Maintenance CapEx + Excess Depreciation

Here's Union Pacific's adjusted earnings calculation (using the figures from the previous steps):

  • Normalized NOPAT (FY 2023): $8,529M
  • Maintenance CapEx: $1,904M
  • Excess Depreciation: $258M

Adjusted Earnings [UNP; FY 2023] = $8,529M - $1,904M + $258M --> $6,844M

Our EPV financial model for Union Pacific below also demonstrates this entire process:

| Stablebread
Union Pacific (UNP): Adjusted Earnings

Thus, Union Pacific's adjusted earnings (aka normalized earnings) for FY 2023 are $6,884M after adjusting for maintenance CapEx and excess depreciation. This figure represents the company's sustainable earnings power and will be used in the final step of the EPV valuation to determine its intrinsic value.

Step #7: Determine the Cost of Capital

After going through the process of calculating the adjusted earnings, the next step is to determine the cost of capital, which represents the minimum rate of return that a company must earn on its investments to satisfy its investors, considering the risk involved.

As mentioned earlier, the weighted average cost of capital (WACC) can be used, but using your own personal required rate of return for an investment, such as ~10% (the market's average annualized return), is recommended because of the inherent flaws in the WACC, which relies on the capital asset pricing model (CAPM) and beta.

Moreover, you may need to adjust this rate upwards based on the current risk-free return, such as U.S. Treasury bills, to ensure a more realistic estimate. For example, if the risk-free rate is 3%, you might consider using a cost of capital of 13% (10% + 3%) to reflect that the spread between 10% and 3% may not adequately compensate for the excess risk taken by investing in the stock.

For demonstration purposes, and because a personal required rate of return is subjective to the individual investor's circumstances, we'll use a relatively simple WACC calculation as our cost of capital for Union Pacific in FY 2023. This is completed in our EPV financial model, as shown below:

Union Pacific (Unp): Wacc
Union Pacific (UNP): WACC

Here's the completed WACC calculation for Union Pacific as well, for your reference:

RWACC [UNP; FY 2023] = (0.185 × 0.0392 × (1 - 0.2252)) + (0.815 × 0.1033) --> 0.0898 or 8.98%

Based on this WACC calculation, Union Pacific's cost of capital is estimated to be 8.98% for FY 2023. This figure will be used as the discount rate in the final step of the EPV valuation to determine the company's intrinsic value. By comparing the adjusted earnings to this cost of capital, we can assess whether Union Pacific is generating sufficient returns to create shareholder value.

Step #8: Calculate and Interpret the EPV

The final step of the EPV valuation is to calculate the EPV, adjust the value for any non-operating assets and liabilities, and then compare it to the company's market cap to determine the company's valuation. Dividing the adjusted EPV by the company's shares outstanding and adding a margin of safety is also recommended to help in your interpretation of the model.

EPV Calculation

Begin by calculating the EPV, by simply dividing the adjusted earnings ($6,884M) by the cost of capital (8.98%), as shown below for Union Pacific:

EPV [UNP; FY 2023] = $6,884M / 0.0898 --> $76,650M

The $76,650M represents Union Pacific's total intrinsic value based on its sustainable earnings power, assuming no growth and a constant cost of capital. This value includes both equity and debt components of the company's capital structure.

Next, adjust the EPV for any non-operating assets and liabilities (from the company's balance sheet) to derive the value attributable to common stock shareholders:

  • Add cash & equivalents and short-term investments to the EPV, as they represent assets that can be used to generate additional value for shareholders.
  • Subtract total debt and minority interest from the EPV, as they represent claims on the company's future cash flows and reduce the value available to equity holders.

This EPV equity value can then be compared to the company's market capitalization to determine its valuation. However, for a more precise comparison, dividing the EPV equity value by the number of shares outstanding yields the intrinsic value per share, which can be directly compared to the current market price.

Here's the completed EPV calculation and valuation, with a relatively low 10% margin of safety added to account for potential estimation errors and to provide a conservative estimate of the company's intrinsic value:

Union Pacific (Unp): Epv Valuation
Union Pacific (UNP): EPV Valuation

As you can see, after dividing the EPV equity value ($43,542M) by the company's shares outstanding ($610M), we get an intrinsic share price of $71.38. Considering a margin of safety of 10% yields our actual buy price for the company, at $64.24 ($71.38 × (1 - 0.10)).

EPV vs. Market Price

Interpreting the results of an EPV calculation is like any other intrinsic value calculation:

  • Undervalued: EPV > Market Price
  • Fairly Valued: EPV = Market Price
  • Overvalued: EPV < Market Price

In the case of Union Pacific, even if we are to ignore our 10% margin of safety, the company's intrinsic share price ($71.38) is well below the company's current stock/market price ($246.30). This suggests the company is very overvalued, at least according to our EPV valuation and assumptions made throughout the model.

Regardless, it's important to note that small tweaks to the model, particularly a lower discount rate, could make the company look more fairly priced. This highlights the importance of conducting sensitivity analyses to assess the impact of changes in key assumptions on the final valuation.

EPV vs. Asset Reproduction Value (ARV)

Lastly, as discussed in Value Investing: From Graham to Buffett and Beyond, comparing the EPV to the company's asset reproduction value (ARV; the cost to replicate the company's assets) can also provide insights into its competitive advantages:

  • EPV > ARV: Suggests that the company has a strong competitive advantage, such as a well-established brand, superior management, or a loyal customer base.
  • EPV < ARV: Indicates that the company's earnings are not sustainable, or it's facing competitive pressures and/or operating in a challenging industry.

We can use Union Pacific's balance sheet, shown below, to calculate the company's asset value:

To estimate the company's ARV, start with the company's balance sheet and examine the value of its assets at the end of the most recent operating period. Accept or adjust the stated numbers as needed. Do the same for the liabilities side of the balance sheet. Then, subtract liabilities from assets to obtain the current asset value.

Typically, adjustments might be made for items like obsolete inventory, doubtful accounts in receivables, market value changes in properties, and impaired intangible assets. However, in our case and for simplicity, no adjustments were made.

Here's Union Pacific's ARV calculation for FY 2023, which is simply subtracting the company's liabilities from its assets:

Asset Reproduction Value [UNP; FY 2023] = $67,132M - $52,344M -->$14,788M

This ARV of $14,788M is the same as the company's shareholders' equity because no adjustments were made, representing the residual interest in the assets after deducting liabilities.

Comparing this to the equity EPV of $43,542M, which includes the company's net debt, indicates that Union Pacific has strong competitive advantages, such as effective management and a solid market position, due to the significantly higher EPV.

In our case, because Union Pacific's intrinsic value is overvalued and their EPV is greater than the asset reproduction value, it indicates that the market is potentially overvaluing the company.

In any case, performing a thorough ARV analysis would make this entire valuation analysis more comprehensive and useful.

Limitations of Earnings Power Value (EPV)

While the Earnings Power Value (EPV) method remains a useful tool for estimating a mature company's intrinsic value, it has several limitations that investors should be aware of before relying solely on this approach:

  • Ignores Growth Potential: The EPV method assumes that a company's current earnings will remain constant in perpetuity, without considering any potential for future growth. This assumption may lead to an undervaluation of companies with significant growth prospects, as the method fails to capture the value of future earnings growth.
  • Sensitive to Normalization Assumptions: The accuracy of the EPV calculation heavily depends on the assumptions made when normalizing earnings. Factors such as the length of the business cycle, the sustainability of current margins, and the choice of the normalization period can significantly impact the final EPV estimate. If the normalization assumptions are not representative of the company's true earnings power, the resulting valuation may be misleading.
  • Overlooks Competitive Advantages: The EPV method does not explicitly account for a company's competitive advantages or economic moat. These factors can have a significant impact on a company's ability to maintain its current earnings power and protect its market share in the long run.
  • Short-Term Focus: The emphasis on current earnings in the EPV method may cause investors to overlook important long-term factors that could affect a company's value. Industry trends, regulatory changes, technological advancements, and shifts in consumer preferences are examples of factors that may not be reflected in a company's current earnings but could have a material impact on its future performance.
  • Reliance on Historical Data: EPV calculations are based on historical financial data, which may not always be indicative of a company's future performance. The method assumes that the past is a reliable guide to the future, which may not hold true in rapidly changing industries or during periods of economic upheaval.
  • Perfect World Assumption: The EPV method assumes that the conditions surrounding a company's operations will remain constant and ideal. It does not account for any internal or external issues that may affect the company's production rate or profitability. This assumption may not hold in the real world, where companies are subject to various risks, such as macroeconomic factors, supply chain disruptions, personnel issues, and regulatory challenges.

Despite these limitations, the EPV method remains valuable for investors seeking a conservative estimate of a company's intrinsic value. When combined with other valuation techniques, the EPV method can provide meaningful insights into the potential undervaluation or overvaluation of a stock. Regardless, investors should be aware of the method's limitations and exercise caution when making investment decisions based solely on EPV estimates.

The Bottom Line

The Earnings Power Value (EPV) method is a straightforward and effective approach to estimating the intrinsic value of a company's stock. By focusing on the sustainability of current earnings and the cost of capital, EPV removes the need for speculative growth projections and provides a conservative estimate of a company's true worth.

EPV is particularly useful when evaluating mature, stable businesses with predictable cash flows. However, it is less suitable for high-growth companies or those with significant competitive advantages that are not captured by current earnings.

Investors should keep in mind that EPV is just one valuation model and should not be used alone. Combining EPV with other valuation methods, such as asset reproduction value (ARV), along with a thorough qualitative assessment of the company's business model, management, and industry dynamics, will provide a more complete understanding of a stock's investment potential.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.

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