How to Analyze Growth in Earnings Power?
The factor that sets the EPV apart is its assumption around no growth, contrary to other methods like the DCF approach – which are reliant on operating assumptions and growth projections.
But to ensure there is no misunderstanding, the company exhibiting no growth also means no change in incremental growth (i.e. there is no growth Capex).
The EPV derives the fair value of a company assuming the current state of its earnings is sustainable, akin to the terminal value.
The growth variable is isolated here to focus on the most reliable part of a business:
- Growth Projection → Forecasting the growth trajectory of a company is easier said than done, particularly across longer time frames.
- Value Creation → Growth in revenue (the “top line”), contrary to a common misconception, does not cause the intrinsic value to rise unless there is real value creation.
In short, growth contributes no incremental value unless the return on invested capital (ROIC) exceeds the cost of capital (WACC).
Earnings Power Value Formula (EPV)
The formula to calculate the earnings power value (EPV) divides the adjusted earnings of a company by its cost of capital (WACC).
Earnings Power Value (EPV) = Adjusted Earnings ÷ Cost of Capital (WACC)
Where:
- Adjusted Earnings = Operating Income (EBIT) × Average Operating Margin (%)
- Cost of Capital (WACC) = [kd × (D ÷ (D + E))] + [ke × (E ÷ (D + E))]
The cost of capital (WACC) is the blended rate of return expected on an investment based on its cost of debt (kd) and cost of equity (ke).
The adjusted earnings equal the product of a company’s reported operating income (EBIT) and the average operating margin.
Adjusted Earnings = Operating Income (EBIT) × Average Operating Margin (%)
The average operating margin is measured across three to five years to ensure that at least one full economic cycle is captured.
From the adjusted earnings metric, the NOPAT – or “Net Operating Profit After Taxes” – a capital structure independent measure of profitability that neglects the effects of interest is computed.
- NOPAT = Adjusted Earnings × (1 – Effective Tax Rate)
The EPV formula discounts the stream of adjusted earnings to the present date, using the cost of capital (WACC) as the discount rate.
Earnings Power Value (EPV) = Earnings Power × (1 ÷ WACC)
Where:
- Earnings Power = Reinvestment Rate × ROIIC
The earnings power is the product of the reinvestment rate and the return on incremental invested capital (ROIIC).
Briefly, the earnings power represents the opportunities to deploy incremental capital by an investor, as well as the expected return on the pursued opportunities.
Earnings Power Value Calculator (EPV)
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Adjusted Earnings Calculation
Suppose we’re tasked with calculating the earnings power value (EPV) of a company given the following historical financial data.
| Earnings Power Value (EPV) |
2020A |
2021A |
2022A |
2023A |
2024A |
| Net Revenue ($ in millions) |
$125 |
$133 |
$138 |
$142 |
$145 |
| % Growth |
– |
6.0% |
4.0% |
3.0% |
2.5% |
| EBIT ($ in millions) |
$49 |
$52 |
$55 |
$57 |
$60 |
| % Operating Margin |
39.0% |
39.5% |
40.0% |
40.5% |
41.0% |
The current net revenue, or sustainable revenue, is $145 million – i.e. the net revenue at the end of 2024.
The adjusted EBIT can be determined by multiplying the current net revenue by the average operating margin.
For the average operating margin input, we’ll use the AVERAGE function in Excel to calculate the average operating margin in the trailing five-year period.
=AVERAGE(E9:I9)
The average operating margin is 40%, which we’ll multiply by the current net revenue to arrive at an adjusted EBIT of $58 million.
- Adjusted EBIT = 40% × $145 million = $58 million
In the next step, we’ll calculate the net operating profit after tax (NOPAT), or “EBIAT”, metric by tax-affecting NOPAT.
We’ll assume the effective tax rate is 21%, which we’ll multiply by the adjusted EBIT.
Since NOPAT is a capital structure neutral metric, the adjusted EBIT is treated as if the metric is earnings before taxes (EBT), i.e. no interest expense.
The income tax provision is $12 million, which we’ll deduct from adjusted EBIT, resulting in a NOPAT of $46 million.
For the capital expenditure (Capex) assumptions of our company, we’ll use the following:
| Capital Expenditure (Capex) |
2020A |
2021A |
2022A |
2023A |
2024A |
| Capital Expenditure (Capex) ($ in millions) |
$15 |
$15 |
$15 |
$15 |
$15 |
| (–) Growth Capex |
($1) |
($1) |
($1) |
($1) |
($1) |
| Maintenance Capex |
$14 |
$14 |
$14 |
$14 |
$14 |
| Capex Assumptions |
|
|
|
|
|
| Total Capex % Revenue |
12.0% |
11.5% |
11.0% |
10.5% |
10.0% |
| % Growth Capex |
8.0% |
7.0% |
6.0% |
5.0% |
4.0% |
| % Maintenance Capex |
92.0% |
93.0% |
94.0% |
95.0% |
96.0% |
Because of the fact that the percentage distribution attributable to maintenance capex increases relative to growth capex as the company matures, we can make the simplified assumption that maintenance capex equals depreciation.
However, please note that the depreciation expense recorded here is for purposes of calculating the earnings power value (EPV), rather than the total amount recognized on the income statement.
2. Earnings Power Value Calculation Example (EPV)
In the next section of our illustrative exercise, we’ll start by calculating the average depreciation for the historical periods.
The average depreciation comes out to $14 million, which must be adjusted for taxes. However, we’ll use 50% (1/2) of the tax rate for our measure to be conservative.
The adjusted tax rate illustrates how the calculation of the earnings power value (EPV) contains discretionary assumptions – albeit not to the extent of a DCF model.
The term, “Constant Size”, implies there are no discretionary net investments in either working capital or fixed capital (i.e. the purchase of PP&E) beyond the necessary spend related to sustaining the current level of growth.
Hence, the depreciation here is assumed to be equal to maintenance capex, with a minor adjustment – the add-back of excess depreciation on an after-tax basis.
Once a company’s intrinsic value on a per-share basis is determined, the implied stock price can be compared to its current share price to determine if its shares are undervalued, overvalued, or fairly priced by the market.
The intent of the tax adjustment was to arrive at an estimate of distributable cash flow to better reflect the actual amount that owners could remove from their business (and the core operations would remain intact).
But to reiterate, there is no standardized method for the EPV valuation approach, so the more important factor is to ensure consistency in the analysis of multiple companies and an understanding of the rationale.
The excess depreciation of $13 million is added back to NOPAT to arrive at an adjusted earnings figure of $59 million.
In closing, the earnings power value (EPV) of our company, or enterprise value, amounts to $732 million, assuming a cost of capital (WACC) of 8%.
- Earnings Power Value (EPV) = $59 million ÷ 8.0% = $732 million
