Using owner earnings to value shares: Earnings Power Value (EPV)

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

Calculation:

1 Normalised or underlying trading profits or EBIT

2. Add back D&A

3. Minus Capex

4. Derive Cash Profit or Owner earning

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

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

7. Minus debt, pension fund deficit, preferred equity and minority interest to get a value of equity.  Add any surplus cash.

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

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

Existing share price  >>> EPV

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

Share price <<< EPV

EPV can be a great way to spot very cheap shares.

When you come across a share like this, you need to spend time considering whether its current profits can stay the same, grow 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.  

Example

Company X 2015 ($m)

EBIT 73.7

D&A 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 interest 0

Pension fund deficit 0

Equity value 753.4

Shares in issue (m)   497.55

EPV per share ($) 1.514

Current share price ($)   $3.20

EPV as % of current share price  47.3%

Future growth as % of current share price 52.7%

INTEREST RATES

Some rough 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 debts or volatile profits):  10% to 12%

Very small and very risky:  15% or more.