'Earnings power value': How to tell if a firm has legs

Share prices aren't just useful for checking the value of your portfolio. They can also play a valuable role in analysing a company. Armed with a copy of the latest annual report and some simple maths, investors can easily work out what the stockmarket is currently saying about a company's future prospects.

By doing this, you can reduce the risks of paying too much for a share, and can also pick out potentially undervalued ones. Sometimes you will find stocks where the share price is implying that profits may never grow again, or may even fall. If the rest of your analysis suggests that fate is unlikely, then you may have found a bargain.

Introducing earnings power value

The idea we're going to use here is called earnings power value (EPV). It was developed by a Columbia University professor, Bruce Greenwald, based on the investment philosophy of famed value investors Benjamin Graham and David Dodd. It involves calculating the earnings power of a company by looking at its profits over a long period of time and estimating what the average profits will be, taking into account all likely business conditions. This estimate is then capitalised by the rate of return we believe the company needs to offer investors, to give a valuation for its current earnings.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

By comparing this with the current share price, we can see whether the company appears to be overvalued or undervalued. A company's value can be broken down into two parts: one based on the value of its current profits and another based on how they are expected to grow. If you can find a stock trading for less than its current earnings alone are worth, it could be an attractive investment as long as the business is not in long-term decline.

While Greenwald uses a long-term estimate of earnings power, you could also use the company's current level of profits, if you believe that they are sustainable. We'll use this method in our calculation. The key steps are:

1. Take the company's most recent annual operating profits.2. Tax this figure at the company's full tax rate to be conservative.3. Divide the result by your required return to get the EPV.4. Take away any debt or pension deficits and add any cash balances to get the value of the firm's equity.5. Divide the equity by the number of shares to give a value per share.6. Compare your value with the current share price.

When Next was cheap

As usual, the best way to explain this is to look at an example. Bargains are often found when the market is crashing and people are gloomy. March 2009 marked the nadir of the financial crisis and the share prices of many good-quality companies were at a low ebb. Clothing retailer Next was one of these firms.

In the table (left), I've set out the EPV calculation for Next in March 2009 and also as of this month. As you can see, back then the market took a grim view of Next's prospects. Its EPV was 163% of the share price at the time.

The shares looked cheap if its then-current profits continued.

The following five-and-a-half years have shown that investors were too pessimistic. Earnings have risen strongly and the company's earnings power value has more than doubled. But now Next's stock valuation is richer. Its current earnings power explains just under 70% of the current share price. The remaining 30% is explained by assumptions for future profits growth.

This makes its shares much morerisky than they were in 2009.Yes, they might still be a good buy,but you are having to pay for growth. Back then, that wasn't the case: youwere getting the growth prospects and more for free. In Graham and Dodd language, there is a much lower "margin of safety" on this investment today.

Four questions to ask about profits

No valuation model is perfect and the danger with the EPV calculation is that the profits that it is based on will not be sustained. To reduce the risk of being too optimistic, you should ask the following questions about your EPV calculation:

1. Does the operating profit figure contain any one-off items that distort the results that arise from trading? If so, adjust the profits accordingly.

2. Is the depreciation figure representative of how much it costs to keep the assets in good condition? If not, reduce trading profits by an extra amount.

3. Are profits cyclical? Are you basing your estimate of EPV on profits that are currently too high or too low? If so, estimate an average level of profits through the cycle.

4. Can a competitor enter the company's markets and reduce the level of sustainable profits? If so, estimate what profits might be if the going gets tougher.