Do you want to know how much a particular company or stocky is worth? The earnings power value model is a great way to calculate the intrinsic value of a stock. In this step-by-step guide, we will show you how to use the earnings power value model to estimate the intrinsic value of stocks, following a free spreadsheet template that will allow you to calculate this value more efficiently.
What is the Earnings Power Value Model, and what are its benefits?
The earnings power value model is a valuation method that uses adjusted earnings and a company's Weighted Average Cost of Capital (WACC) to estimate the intrinsic value of a stock. The fundamental assumptions of this model are constant profits and no forecasted growth. Once a company's intrinsic value is calculated, it can be compared with its current share price or market capitalization to asses if it's overvalued or undervalued.
The main benefit of this model is that it is relatively simple to calculate and does not require making projections for a company's earnings or cash flow.
How to calculate EPV for a company
The basic formula to calculate the earnings power value model is:
Earnings power value = Adjusted earnings/ WACC
However, there are many steps needed to properly calculate a company's adjusted earnings and WACC. Below you will see how the calculation is done for Apple.
Step 1 – Calculate the average Earnings Before Interest and Taxes (EBIT) margin
The first step is to calculate the company's average or median EBIT margin. Typically the last five years of fiscal year data is used to calculate this number so that any one-time events are not included.
Keep in mind that the EBIT is the same thing as the operating income, and in this case, we will be calculating this figure for Apple.
Step 2 – Normalize EBIT
To normalize EBIT you need to find the company's current sales, either in the latest fiscal year or Trailing Twelve Months (TTM), and then multiply this number by the average operating income ratio. This allows you to estimate what the company's operating income or EBIT will be.
After this, you need to subtract the average income tax ratio of the company from the normalized EBIT figure.
As you can see, you will be left with the after-tax normalized EBIT.
Step 3 – Add depreciation
Since depreciation is not an actual cash expense for companies, you need to add it back to the after-tax normalized profit to calculate the normalized profit.
You can do this by calculating the average depreciation in the last 5 years and then multiplying it by 0.5 and the income tax ratio average. You will be left with the adjusted depreciation that you can then add to the after-tax normalized EBIT.
The reason why you multiply the average depreciation by 0.5 or 50% is that it represents an assumption that 50% of the depreciation expense reported is not an actual real expense that the company has to pay but rather a way to increase expenses and pay less income tax.
Step 4 – Calculate the required maintenance Capital Expenditures (CAPEX)
For this step, you need to calculate the average capital expenditures and net income growth of the company in the last 5 years. Then take the average CAPEX and multiply it by 1 minus the average net income growth.
With these calculations, you will get the real maintenance CAPEX expense the company needs to maintain its current profits because you exclude the growth in income that the capital expenditure expense provides the company.
Step 5 – Calculate the gross earnings power value
Now that you have calculated the normalized profit and adjusted maintenance CAPEX subtract the difference between the two numbers and this will provide you with the adjusted earnings.
Once you have the adjusted earnings, all you need to do is divide this number by the WACC. You can check out this guide on how to calculate the WACC of a company, but you can also Google this value so you can use it in the formula.
Step 6- Calculate the earnings power value
Now that you have the gross earnings power value, all you need to do is add the cash and cash equivalents that the company has and subtract the total debt.
This results in the earnings power value number, which is similar to the enterprise value of a company because the cash was added and debt was subtracted.
Step 7 – Calculate earnings power value per share (optional)
Once you are done with the calculation above, you can divide this number by the company's number of shares which provides you with the intrinsic value per share of the stock.
As you can see, for Apple, according to this valuation method, only, the value of the company is about $58 per share.
If you want to calculate what that implies in terms of potential upside and downside of the stock given the current share price, do the following calculation:
Upside/downside = (earnings power value per share – current share price) / current share price.
Given the current share price of $167, this represents a downside of 65% based on this valuation method alone.
Of course, if you change some of the model assumptions like the WACC, maintenance CAPEX etc. you will get a different intrinsic value per share.
Free earnings power value model spreadsheet
As you can see, each of these steps was calculated using the spreadsheet you can see below:
By simply changing the company's ticker, WACC and other important assumptions, you can get the earnings power value model number automatically without the pain and hassle of having to copy-paste the data for every company you analyze.
The data comes directly from Wisesheets using custom spreadsheet functions which retrieve the data from the company's financial reports.
You can get the spreadsheet free by creating a free trial account at Wisesheets, downloading the Excel add-on, and then downloading it from the templates section.
How to find undervalued stock using the earnings power value model?
The best way to use this model is to calculate stocks' intrinsic value. This allows you to find if any particular stocks are undervalued or overvalued.
- If a stock price is higher than the intrinsic value, the stock may be overvalued
- If a stock price is lower than the intrinsic value, the stock may be undervalued
The main thing to keep in mind is that this is only one way to assess the value of a company, and therefore, should be used in conjunction with other evaluation methods such as a DCF or the multiple method valuation method for better results.
Lastly, be mindful that your assumptions may be off, and therefore, it is best to invest in companies where the intrinsic value is significantly lower than the stock price to provide you with a margin of safety. Typically 20% or more below the intrinsic value is considered a good investment opportunity.
Earnings Power Value VS Discounted Cash Flow model (DCF)
The earnings power value model is an excellent way to assess the value of a company, but it should not be used in isolation.
A discounted cash flow model is another excellent method that you can use to find the intrinsic value of a stock.
You can read check out our article on how to download and use a free DCF template in Excel.
When doing a DCF, you are valuing the company based on all the cash it is expected to generate in the future. This method differs from the earnings power value, which only focuses on one year's earnings.
The main difference between the two models is that the DCF model takes into account growth or decline in earnings or cash flows, whereas the earnings power value model does not.
The earnings power value is best used in conjunction with the DCF to get a more accurate company valuation.
Both the earnings power value and DCF are great methods to find the intrinsic value of stocks, but they each have their own strengths and weaknesses.
It is up to you to decide which method they prefer or want to use both to get a more accurate valuation.
For what companies is it best to use the earnings power value model?
The earnings power value model is best used for stable companies with debt.
Companies with a lot of debt may not be good candidates for this valuation method because their earnings may be more volatile.
It is also essential to remember that the earnings power value model only focuses on one year's worth of earnings, so it may not be suitable for companies that are expected to have a lot of growth in the future.
In other words, these companies tend to be in the mature stage of the business life cycle.
These companies are characterized by:
- Consistent sales
- Reduced costs
- Increased sales
- Modest growth
Overall, the EPV model is a great way to value stable companies with little debt andature in the business lifecycle.
The earnings power value model is a great way to find the intrinsic value of stocks. It is best used for stable companies with little debt ande stage of the business life cycle.
You can use the earnings power value model in conjunction with other valuation methods, such as a DCF, for a more accurate valuation.
Don't forget to download our free earnings power value spreadsheet to make this process easier for you.
To your investing success!