Title: Earnings Power Value (EPV): A Practical Guide to Estimating a Company’s Sustainable Cash-Flow Value
Introduction
Earnings Power Value (EPV) is a valuation approach that estimates the value of a company based on the sustainable level of current earnings and the firm’s cost of capital—without relying on explicit forecasts of future growth. Developed and popularized by Bruce C. Greenwald and colleagues, EPV aims to measure a company’s “what it can earn today, forever” value by normalizing earnings and then capitalizing them at an appropriate discount rate. Because it sidesteps growth assumptions, EPV is most useful as a conservative, transparent check on market prices.
Key takeaways
– EPV = Adjusted (normalized) earnings / WACC. That gives the value of ongoing business operations.
– To get equity value: EPV (operations) + excess net assets (e.g., surplus cash, marketable real estate) – debt = EPV equity.
– EPV focuses on current, sustainable earnings rather than forecasts of future growth, making it simple but dependent on how well “sustainability” is estimated.
– EPV is best used for stable businesses with predictable earnings; it can understate value for firms where growth is realistic and persistent.
Formula (overview)
– EPV (operations) = Adjusted normalized earnings ÷ WACC
– EPV (equity) = EPV (operations) + Excess net assets − Debt
Step-by-step practical procedure to calculate EPV
Follow these practical steps to compute EPV for a company and interpret the result.
1) Gather historical operating results (at least 5 years, preferably a full business cycle)
– Collect EBIT (earnings before interest and taxes) for the past 5–10 years.
– Use operating income to avoid financing effects.
2) Normalize earnings
– Calculate average EBIT and average EBIT margin over the cycle to smooth cyclical highs and lows.
– Alternatively, use an average of EBIT over the cycle multiplied by a representative revenue level to derive normalized EBIT.
– Remove one-time items that are not part of normal operations (e.g., large asset sale gains, disaster-related expenses) and adjust for recurring unusual charges if they will continue.
3) Convert to after-tax operating profit (NOPAT)
– NOPAT = Normalized EBIT × (1 − Tax rate)
– Use the firm’s average effective tax rate (or a normalized statutory rate if more appropriate).
4) Adjust for non-cash and non-operating items
– Add back sustainable non-cash charges (depreciation if it reflects true economic consumption and not disguised capex shortfalls).
– Remove or add adjustments for unconsolidated subsidiaries, equity-method earnings, recurring restructuring charges, or material accounting policies that distort reported EBIT.
– The goal is an “adjusted” sustainable earnings figure that represents distributable cash generation capacity before financing.
5) Compute WACC (the appropriate discount/capitalization rate)
– WACC = (E/V) × Re + (D/V) × Rd × (1 − Tc)
– Re = cost of equity (often estimated with CAPM: Re = Rf + β × Equity risk premium)
– Rd = after-tax cost of debt (use market yields where available)
– E = market value of equity, D = market value of debt, V = E + D
– Tc = corporate tax rate
– Use market-value weights, and make sure inputs reflect the company’s risk and capital structure.
– If the firm’s capital structure is changing materially, consider an adjusted target-capital-structure WACC.
6) Calculate EPV for operations
– EPV (operations) = Adjusted NOPAT ÷ WACC
– This value represents the capitalized value of the firm’s sustainable operating earnings under current conditions, assuming no growth.
7) Adjust for balance-sheet items to get EPV equity
– Identify “excess net assets” that are not required to run operations and should be available to shareholders: surplus cash, marketable securities, market-value real estate, etc.
– Subtract interest-bearing debt (and any other claims like preferred stock if applicable).
– EPV (equity) = EPV (operations) + Excess net assets − Debt (and preferred obligations).
8) Compare EPV equity to market capitalization
– If EPV equity > market cap, the stock may be undervalued (subject to judgment about assumptions).
– If EPV equity < market cap, the stock may be overvalued relative to its current earnings power.
– Use a margin of safety and consider alternative scenarios.
Worked numeric example (simple)
– Normalized EBIT = $200 million (5-year average)
– Effective tax rate = 25% → NOPAT = $200m × (1 − .25) = $150m
– Adjustments (one-time charges removed, small excess cash of $50m included later)
– WACC = 10% → EPV(operations) = $150m ÷ 0.10 = $1,500m
– Excess net assets (excess cash + market land) = $50m
– Debt = $400m
– EPV equity = $1,500m + $50m − $400m = $1,150m
– If market cap = $900m, EPV suggests the stock is potentially undervalued; if market cap = $1,400m, it might be rich.
Interpretation: What EPV tells you
– EPV estimates the present value of a firm’s sustainable, perpetual cash-generation capacity based on current operations and margins, without assuming future growth.
– It is conservative: by excluding growth, EPV provides a floor value tied to existing business economics.
– EPV can reveal undervaluation if market prices do not reflect the sustainable earnings base or excess asset values.
Limitations and caveats
– Ignores growth: Companies with real, sustainable growth will likely be undervalued by EPV unless growth is captured elsewhere.
– Sensitive to normalization choices: How you normalize earnings and define recurring items materially affects the result.
– Accounting distortions: Non-cash charges, capitalized expenses, goodwill amortization, and off-balance-sheet items can misstate true operating economics.
– Reinvestment needs: EPV assumes earnings are distributable; it may understate the need for maintenance capex or working-capital reinvestment to sustain those earnings.
– WACC estimation: Small changes in WACC materially change EPV; choosing the right discount rate is critical.
– Not suitable for very young, fast-growing, or highly cyclical companies where current earnings are not representative.
Best practices and practical tips
– Use at least a full business cycle of historical data (5–10 years) for normalization.
– Be explicit about adjustments: document each add-back or deduction and why it’s treated as recurring or non-recurring.
– Run sensitivity analyses on WACC and normalized earnings (e.g., ±1% WACC, ±10–20% earnings) to see valuation range.
– Combine EPV with other valuation tools—DCF, comparables, liquidation value—to triangulate a fair value.
– For cyclical firms, consider normalizing using cycle peak-trough averages or using long-term average margins.
– When adding “excess net assets,” use conservative (realizable) estimates—don’t count book values of hard-to-sell assets at face value.
– Use a margin of safety (as with other value-investing approaches) before concluding a buy.
When EPV is most useful
– Stable, mature businesses with predictable earnings and capital requirements.
– Situations where you want a conservative valuation floor that avoids optimistic growth assumptions.
– Value-investing screens to find companies trading below the capitalized current earning power plus surplus assets.
Further reading and sources
– Greenwald, B. C., Kahn, J., Bellissimo, E., Cooper, M. A., & Santos, T. Value Investing: From Graham to Buffett and Beyond. John Wiley & Sons, 2020.
– Investopedia, “Earnings Power Value (EPV)” (summary and practical guidance), Jake Shi. https://www.investopedia.com/terms/e/earningspowervalue.asp
Conclusion
EPV is a straightforward, conservative valuation method that converts normalized current earnings into an estimate of value by capitalizing those earnings at an appropriate cost of capital. It gives investors a clear, assumptions-light benchmark for what a company is worth under “steady-state” conditions. Use EPV as a disciplined starting point, document your normalization and WACC assumptions carefully, and combine EPV with other analyses to form a robust investment view.