Using Earnings Power Value (EPV) to weigh up the value of a share

Earnings Power Value (EPV) is another way to weigh up the value of a share.

EPV gives you an estimated value of a share if its current cash profits stay the same forever.



Calculating EPV

This is how you calculate it.

1.  Take a company's normalised or underlying trading profits or EBIT.

2.  Add back depreciation and amortization.

3.  Take away stay in business capex.

4.  Tax this cash profit number by the company's tax rate.

5.  Divide by a required interest rate# to get an estimate of total company or enterprise value.

6.  Take away debt, pension fund deficit, preferred equity and minority intersts to get a value of equity.  Add any surplus cash.

7.  Divide by the number of shares in issue to get an estimate of EPV per share.



#What interest rate should you use when valuing a business?

All you need to know is that the higher the interest rate you use, the more conservative your estimate of value will be.

Here are some rough and ready guidelines of the interest rates you might want to use when valuing different companies:

• Large and less risky companies:  7% to 9%
• Smaller and more risky (lots of debt or volatile profits):  10% to 12%
• Very small and very risky:  15% or more.

Compare your estimate of EPV per share with the current share price.  

1.   Current Share Price > EPV

For example:
                      EPV per share                    151.4
                      Current Share Price            320 

We can see that the estimate of EPV accounts for less than half of the existing share price.

• A large chunk of the current 320 price is based on the expectation of future profit growth.  

2.   Current Share Price < EPV

EPV can be a great way of spotting very cheap shares. 

Sometimes it is possible to find shares which are selling at a significant discount to their EPV.

• When you come across a share like this, you need to spend time considering whether its current profits can stay the same, or whether they are likely to fall.  
• If profits are likely to fall, it might be best to move on and start looking at other shares.

To minimise the risk of overpaying for a company's shares, you should try to buy when its current profits - its EPV - can explain as much of the current share price as possible.

• As a rough rule of thumb, even if profits and cash flows have been growing rapidly, do not buy a share where more than half its share price is reliant on future profits growth.  

An example of how to calculate EPV

Company ABC  Earnings Power Value ($m)

Underlying EBIT                                      73.6
Dep & Amort                                              6.6
Stay in business CAPEX                           -8.9
Cash trading profit                                    71.3
Tax @ 20%                                              -14.3
After tax cash profits (A)                       57.0
Interest rate (B)                                        8%
EPV = A/B                                                713

ADJUSTMENTS
Net debt/net cash                                      40.4
Preference Equity                                          0
Minority interests                                          0
Pension fund deficit                                       0
Equity value                                          753.4
Shares in issue (m)                                497.55
EPV per share (cents)                           151.4

Current share price (cents)                         320
EPV as % of current share price                47.3%
Future growth as % of current share price 52.7%