DECEMBER 28, 2007

Valuation Technique: Earning Power Value (EPV)

I have discussed in a previous post the discounted free cash flow valuation
method. Another technique I use and prefer is the Earning Power Value and
reproductive asset value (EPV). The reasons why I prefer this technique are many
among them:

1. It ignores growth and future projections of sales. Growth projections are

always faulty and if they materialize it is by sheer luck.
2. Discounted cash flow models ignore the balance sheet and this one
incorporate it as part of the valuation.
3. This method is more conservative.
4. It gives me an indication if management is able to exploit effectively its
assets and competitive advantages.

In the following I will give an overview step by step guide to conducting the
valuation. Valuation is conducted in two separate steps:

1. Estimation of asset reproductive value

2. Determination of EPV

1. Asset Reproductive Value

Asset reproductive value is the cost of assets needed by a new entrant to compete
in an equal manner with an incumbent in the industry. This step can be very
involved and need some industry and company insight. You need the company's
most recent balance sheet to begin. Valuation will be easiest for current asset and
liabilities in general, however more involved with the fixed assets portion of the
balance sheet.
You start with book values of the balance sheet, generally it is easier to value the top items and it gets harder as you go down the account list. In the following I will present a table with each major category of assets and the needed adjustment to be made to arrive at a reproductive asset value.

Account Adjustment
Cash and Generally there is no adjustment needed as cash is cash
marketabl
and marketable securities are marked to market and
e
represent fair value
securities
the reproduction cost is greater than the book value
Account generally, as companies write off bad debt and apply
receivable doubtful debt allowance to AR. At a minimum you add the
s (AR) allowance of bad debt to book value of AR as any new
entrant will experience defaults and such expenses.
In a liquidation scenario it is valued at zero but at an
operating level you have to value it at FIFO basis. If the
Inventory firm is valuing it using LIFO then add the LIFO reserve back
to the balance sheet number to arrive to reproduction
value.
PV of cash savings if the company is anticipating to use
Deferred
them if the company is in no position to use these assets
tax assets
then value them at zero.
Generally this item will never be replaced at less than
original cost. If the land and buildings are a critical then
you have to asses the market value and it is usually
upwards as land are booked on the balance sheet in
historical terms and undervalues current market values.
For example retailers like Home Depot and Sears have
Building & purchased all their location years ago therefore their
Land balance sheet value understates the true economic cost
for a new competitor that want to compete against them.

To get proper value you need to apply similar transaction

values to the company's buildings and land on a location
by location basis. This can be one of the hardest steps in
the process and the more research intensive.
In general there is a long term trend of equipment
efficiency and advancement so historical value of plants
and equipment may be higher than what a new entrant
into the industry might have to pay. Here a familiarity of
the industry production method and technologies will help.
Plants &
Equipment On going plants use the price for unit production capacity
value. What is the market value or production price per
unit of output for other comparable companies. Example,
what is the price of tonnage of aluminum in the market
multiplied by how many tonnage does the plant produce
gives a reproductive value for the aluminum plant.
Intangibles 1. How many years in R&D spending to reproduce a
product? Depends on the industry, in consumer it
 takes 3 years, in car business it takes 6 years.

2. Brands: what is the cost to reproduce the brand?

What is the comparable acquisition price of brands in
the same industry? The acquisition price of some
deals per each dollar of sales of the acquired brand
and apply that multiple to the company sales you are
valuing. Or simply 3 years of marketing and sales
expenditure of the firm
PV of cash to be paid in the future if the company is
Deferred
profitable. But if it is anticipated to generate losses then
taxes
you have to push payment into the future further and will
liabilities
be valued less.
Accounts Book value is a good reproductive value for this account
payable and no adjustment is needed.
Market value of debt as a new entrant will have to issue
Long term debt at current interest rates which may be different than
liabilities the historical prices of the company debt. You can look
these up using yahoo finance.

Please note that if you are attempting this valuation on a viable industry then it is
reproductive valuation. However if the industry is not viable then liquidation
values should apply, in other words serious discounts should be applied to the
assets.
2. Earning Power Value
Earning power value: is the second aspect of the valuation of a
business. Basically EPV is...
A business's ability to generate profit from conducting its operations. Earnings
power is used to analyze stocks to assess whether the underlying company is
worthy of investment. Possessing greater long-term earnings power is one
indication that a stock may be a good investment.
or in a mathematical equation EPV= Adjusted Earrings/ cost of capital
The calculation assumes no growth and current earning is sustainable
over the long run. This is one of the great advantages of the technique
as it does not muddy the valuation process with future predictions. It
evaluate a company based on its current situation. However to arrive
at EPV there are several adjustments to be made to the Earnings
figure as follows:

1. Operating earning or EBT is the start point.

2. You need to adjust EBT for the business cycle and cyclicallity by
taking a 7 year Average of operating earning, which will include
at least one economic downturn. You can do this by averaging
the company's EBT margin over 7 years and apply it to current
 year's sales, and viola it will adjust for cyclicallity and business
cycle.
3. Next deduct the 7 year average of non-recurring charges or
normalize these expenses to reflect their economic nature. Non
recurring charges are part of doing business and they will arise
in the future so I do not see why you need to exclude them.
4. Apply Tax rate the figure derived in step 3, which is the average
tax rate of the company over the last 7 years. Alternatively use
the general 33% corporate tax rate to avoid tax schemes
implemented by different companies.
5. Add depreciation of the most recent year.
6. Next deduct adjusted Depreciation: true depreciation is the cost
to the company to make it at the end of the year in the same
situation at the beginning of the year. Accounting depreciation is
irrelevant as it can be higher because capital goods prices go
down due to technology advancement, or it can be lower in
inflationary environment where reproduction costs is higher then
accounting depreciation underestimates true economic cost, so
you have to adjust for it by using maintenance capital expenses
(CAPEX) as the true measure of depreciation. You can calculate
maintenance CAPEX by:
• Calculate the Average Gross Property Plant and
Equipment (PPE)/ sales ratio over 7 years
• Calculate current year's increase in sales
• Multiply PPE/Sales ratio by increase in sales to arrive
to growth capex
• Maintenance CAPEX is the Capex figure from the
cash flow statement less growth capex calculated above,
which is the true depreciation for the company
7. Cost of capital estimation: estimate by judgment or use
company cost of capital as discussed in my earlier post here.
8. Divide the adjusted earnings calculated in step 6 by cost of
capital in step 7 to get EPV.

The final step is to compare the per share reproductive asset value in
step 1 (Assets-liabilities/ # of shares) to EPV per share calculated in
step 2 and you got a value of the business. Companies with
sustainable competitive advantage should have a higher EPV than
asset value and the difference is the franchise value. If the reverse is
true management is destroying shareholder's value by earning less
that the assets capability and you can conclude that the business is a
commodity business with no attractive ROIC profile.
If you require more details on this technique, I recommend buying Bruce Greenwald's book: Value Investing: from Graham to Buffett and Beyond. I also recommend watching the following lecture by Prof Greenwald about the subject, you can view it here.
I hope the above helps.

_____________________________
Sources: Value Investing: from Graham to Buffett and Beyond by
Bruce Greenwald, Security Analysis by Graham and Dodd,
Investopedia.com