Some people have stressed on referring to a few different metrics when analyzing a company. And they are rightly so.
In this part 3 sequel of the posts, I will share on one of the earnings valuation methodology favored by Bruce Greenwald which is best used in conjunction with the Reproduction Cost value method discussed in the previous post.
Just like how the balance sheet had to be adjusted in the Reproduction Cost method, the income statement had to be adjusted this time in the EPV (Earnings Power Value) method.
The EPV method of valuing earnings are constantly being debated and compared against the more known DCF (Discounted Cash Flow) and DDM (Dividend Discount Model) used across tertiaries and research house. The biggest difference amongst the 3 valuation methodology, as you will see later, is that the latter two takes into account future potential growth and earnings optimism while the EPV method doesn't.
As mentioned previously, the EPV method is best used in conjunction with the Reproduction Cost method, and are suitable to value companies whose cash flows are more volatile and has a young history. So here we go.
The concept of EPV starts with EBIT and begin working through items to adjust from it.
1.) Consider historical trough or peak
The idea is to adjust historical EBIT or EBIT margins based on cyclical business conditions through volatile economic conditions during trough and peak and even them out. This is to ensure that you do not account only for a year of profitability.
2.) Adjust for one-off or extraordinary items
You need to add back any one-off cost or extraordinary items into the EBIT since this does not represent future earnings value. Similarly, any one-off income will need to be deducted from the EBIT.
3.) Add back SG&A and R&D expenses
Greenwald proposed adding back 25% of SG&A and R&D expenses into the EBIT.
The rationale for adding these items back is to account that these costs are expected to provide future earnings benefit to the company, so considering that the EPV method is ignoring terminal growth rate like what is used in DCF, 25% is used as a conservative figure.
4.) Add back Depreciation & Amortization
Greenwald proposed adding back 20-25% of Depreciation and Amortization expenses into the EBIT.
The amount of percentage to be added back depends on the type of accounting treatment used to depreciate the assets. Use this constantly when adding back the PPE on the Reproduction Cost method.
5.) Deduct Maintenance Capital Expenditure
Last but not least, deduct the average amount of maintenance CAPEX used to operate the business.
Once this is done, you get your adjusted EBIT figure and do the same by discounting* them to get your Net EPV.
*Rather than using WACC where you have to work out the CAPM based on specific beta, it will be easier to use a range of discounted rate for discounting purpose.
After you get your Net EPV, compare them with your Reproduction Cost value you have computed earlier. There would be 3 cases you would end up with.
Case A: Asset Value > EPV. In this case, the company has no moat, no strategic advantage, bad management and in a sunset industry.
Case B: Asset Value = EPV. In this case, the company has no moat and is in a competitive industry where companies are earning only their cost of capital. Free entry and exit barrier.
Case C: Asset Value < EPV. In this case, the company has a strong moat, brand recognition, good management and in a sunrise industry.
Comparison with DCF method
DCF method of valuing companies based on earnings is one of the most commonly used across analyst's research house and education tertiaries. The reason why they are being commonly used is because of its simplicity to implement, but Greenwald thinks otherwise. He thinks there are ways too many assumptions and importance placed on future growth that makes the DCF rather unconservative. This is the very same reason why you always see analysts putting high target price for growth companies.
Another notable difference with the DCF method is probably that DCF requires consistent cashflow throughout the predictive nature of the business. This isn't always the case, unless we are talking about companies with predictable recurring income.
In case anyone out there wants a comprehensive template for computing the DCF method, you can contact me at my personal email and I will send you the file. The template is comprehensive as it covers a whole range of additional things such as sensitivity risk of WACC and growth rate, inflation, ROI and plowback ratio. They are done during one of the classes in my MBA program. Here's a preview below.
Conclusion
There are no one fits all type of valuation methodology.
The DCF is still one of the most commonly and easiest to use across earnings valuations methodology. If you are uneasy about putting future growth expectations on DCF methodology, you can either increase the discount rate or use a reverse DCF methodology to find out the current market growth expectations based on current price.
If I were to choose, I'll probably use the lower of the two method for conservative purpose when analyzing a company. Again, the devils is always in the detail you put in.
What about you? Which type of earnings valuation do you prefer and why?
