By Adam Parris. Originally published at ValueWalk.
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.”
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.
Marign Growth?
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
The post The Step by Step Investment Process for Earning Superior Returns – Part II appeared first on ValueWalk.
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