Assessing the Earnings Power Value (EPV)
Earning Power Value can be thought of as Intrinsic Value. In the 2013 Berkshire Hathaway annual report, Buffett explained what intrinsic value means.
“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie [Munger] and me – will almost inevitably come up with at least slightly different intrinsic value figures.”
Seth Klarman On Margin Of Safety Investing
This is part nine of a ten-part series on some of the most important and educational literature for investors with a focus on value. Across this ten-part series, I’m taking a look at ten academic studies and research papers from some of the world’s most prominent value investors and fund managers. All of the material Read More
I mentioned in part I how important it is, not to take earnings at face value, the reported earnings can be manipulated and many companies report earnings via EBITDA. That is earnings before interest [payments], tax [payments], depreciation [on past capital expenditure spent on plant and equipment] and amortization [on the purchase of past intangible assets]. Essentially implying these items are not costs to the business, it’s their way of reporting earnings better than what actually occurred. Ego is the core reason why they participate in manipulating earnings.
The first step requires assessing the value of current earnings, properly adjusted. This requires us to make certain assumptions about the relationship with future earnings and currents earnings.
The equation for earnings power value is: EPV = Adjusted Earnings X 1/R
- R = Your Discount Rate (think of it as your require rate of return).
Here we aren’t going to add forecasted earnings to our equation, instead, we are going to arrive at an accurate estimate of the current earnings of the company by refining the earnings data.
There is a sane approach to analysing the future cash flows that does not involve some arcane highly complex mathematical formula. It involves assessing the strength of the company’s competitive advantages, to determine if they can continue to generate growing cash flows well into the future – 20 years’ time. That’s why investing is half art and half science.
BUT before we jump straight into discounting the cash flows of a business, we need to adjust the current earnings and assess the quality of those earnings.
Here we have added back depreciation and amortization, as they don’t affect the cash flows for the current period, but make no mistake they are a real cost which is why we deduct the cost of investment required back into the firm in the form of PPE to maintain the current level of sales, referred to in the table as maintenance capex. This is why reporting earnings based EBITDA is inappropriate, and morally wrong by the company’s executive personal.
There is a difference of $137 million!
As you can see above due to accounting practices we need to adjust earnings to reflect the true earnings of Kors.
Calculations for Maintenance Capex.
Below are the calculations for determining the amount of money needed for capital expenses to maintain current sales, excluding capital spent on growth. These amounts were used to calculate Maintenance Capex in the above table.
Assessment of Competitive Advantages
The first question to ask is if the firm enjoys competitive advantages?
Let’s apply a logical process, you could choose the scientific method or a quick method to use is the decision tree diagram from Competition Demystified by Greenwald & Kahn, it’ll prove quite useful too.
We’ll use the scientific method, so I can also quote a passage from Zen & the Art of Motorcycle Maintenance by Robert Pirsig.
“Actually I’ve never seen a cycle-maintenance problem complex enough really to require full-scale formal scientific method. In motorcycle maintenance things are not that involved, but when confusion starts it’s a good idea to hold it down by making everything formal and exact. The real purpose of scientific method is to make sure Nature hasn’t misled you into thinking you know something you don’t actually know.”
Part I of the scientific method is to state the problem. Solve problem: Does Kors enjoy competitive advantages? You do need to avoid jumping to conclusions by inserting a question like ‘what is wrong with Kors rates of return on equity? As you may notice while you are adjusting Kors earnings that return on equity is declining over the years, but you don’t absolutely know if the problem lies within the rates of return on equity. Plus another problem is that the wrong statement can mislead us down the wrong path.
Part II: State the hypothesis. Here we can apply four standard hypotheses.
Hypothesis number one: Does Kors enjoy supply advantages?
Hypothesis number two: Does Kors enjoy demand advantages?
Hypothesis number three: Does Kors enjoy economies of scale?
Hypothesis number four: Does Kors enjoy more than one competitive advantage?
Part III requires us to test each hypothesis, and hypothesis 1-3 each have their own tests and the last hypothesis tests to see if Kors enjoys overlapping competitive advantages, for example, supply advantages are strengthened when economies of scale exist alongside it.
It would be unfair to paying members to reveal more, so I leave you to finish the scientific method. But two quick tests you can apply is to compare the return on equity and margins of all competitors within an industry.
Return on Adjusted Equity
Competitive Advantages???? Operational Efficiency will be the key focus for Kors.
Remember this rule of thumb as to why, over the long term, share prices increase.
Each share is a piece of ownership in the equity of the business, equity increases due to growth in retained earnings, and earnings increases when the growth in sales occurs faster than growth in costs. So, rising net earnings increases equity, and increases of equity increase the value of each share.
From the above Return on Equity table, how much are you willing to pay for a share of the equity, considering the declining rates of return on equity?
EPV of Kors with different discount rates
The market census is discounting at approx. 11%. But it should be noted that to fairly compare EPV to Market price, the debt would need to be subtracted from EPV and it EPV ignores interest payment and interest receipts on cash.
What discount rate you apply will depend on your desired rate of return.
Asset valuation & EPV valuation.
The assets are earning $3 billion dollars in excess of their value. This will attract competition, and only barriers to entry will prevent them from eroding this value.
But if current declining trends in margins continue (including return on equity), probably due to competition, the EPV will fall to the same level as the asset value. This commonly occurs when a firm doesn’t enjoy competitive advantages.
If the inverse occurs, where the EPV is lower than the asset value, value is being destroyed. Most commonly occurs in the mining sector, especially mining exploration companies.
There is one more step before making a decision to buy.
Understand that there are limitations to applying the whole investment process, and it is of vital importance to incorporate a margin of safety into your process. You can apply a 30% margin of Safety to the purchase price of a stock, which will protect you to some degree against any errors made during the investment process. As per the excerpt below, the margin of safety concept can be applied in other ways.
“MARGIN OF SAFETY” as the Central Concept of Investment [Title of chapter 20, The Intelligent Investor] Author Benjamin Graham
[Excerpt] All experienced investors recognize that the margin-of-safety concept is essential to the choice of sound bonds and stocks. For example, a rail road should have earned its fixed total charges better than five times (before income tax), taking a period of years, for its bonds to qualify as investment-grade issues. This past ability to earn in excess of interest requirements constitutes the margin of safety that is counted on to protect the investor against loss or discomfiture in the event of some future decline in net income……There are instances where a common stock may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only common stock that under depression conditions is selling for less than the amount of bonds that could safely be issued against its property and earning power.[End]
Cognitive bias will affect decisions you make during the process, and incorporating the margin of safety concept is one way to protect you from falling prey to a variety cognitive bias. Deep presence cultivated through a meditative practice will also help you avoid the cognitive bias trap door.
It is important to understand that once you find the perfect undervalued stock, it will take some time for the share market to catch up. It’s an element outside of our control. Skill plays a small role compared to luck over the shorter term.
“We are responsible for some things, while there are others for which we cannot be held responsible. The former include our judgement, our impulse, our desire, aversion and our mental faculties in general; the latter include the body, material possessions, our reputation, status – in a word, anything not in our power to control.” Enchiridion, Ch1  – Epictetus
A core tenant of Stoicism is what Epictetus referred to as, focusing on what is in our power to control, the quality of own thought process and investment analysis, and avoiding what is not within our power to control, the short-term share price fluctuations and others people’s opinions.
And Benjamin Graham’s most talked about quote, ‘in the short term the market is a voting machine and in the long term is a weighing machine’ provides us with a great perspective for viewing share prices movements.
One of the biggest mistakes made by investors is that their focus is directed at the share prices of businesses as reflected on the share market, and not directing their attention to the investment process itself. As Warren Buffett has pointed out, games are won the playing field, not by watching the scoreboard.
In Part III we can use the methods in part I & II to help us narrow our search to find investment opportunities.
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