Earnings Power Value EPV and Book Review


What You Will Learn

  • How to use the EPV and improve your investing
  • How you can calculate the EPV to value stocks better
  • What the disadvantages of EPV are
Greenwald EPV Value Investing

Greenwald EPV Value Investing

It took me a year or so to purchase the book and then another month or so until I finally got around to reading it but Value Investing: From Graham to Buffett and Beyond is definitely a great addition to the serious investor. Rather than a “book review” it’s more of a discussion on Greenwald’s valuation methods.

If you are new to investing or lack confidence in reading the financial statements and making adjustments to the numbers, then skip this one for now and try looking into either F Wall Street or Five Rules for Successful Stock Investing.

Quick Overview

The book is broken down into 3 parts.

  • Part 1: Introduction to value investing
  • Part 2: 3 Sources of Value
  • Part 3: Profile of 8 value investors

After reading a few sentences of part 1 and part 3, I immediately skipped over it. Nothing new to add to the already vast quantity of books defining value investing, the pros and cons of DCF, and some background info on value investing greats.

The sole reason I bought the book was for part 2 alone so let me get on with it.

Part II: Three Sources of Value

The section starts off with why DCF valuation is unreliable, and then goes over a 3 step valuation technique to mitigate the risk of making too many predictions associated with discounted cash flow analysis.

The three described are:

Benjamin Graham’s asset valuation.

Basically the same as Graham’s Net Net Working Capital asset valuation except Greenwald includes some adjustments to the balance sheet to include other assets such as property and goodwill in special cases.

Greenwald also refers to this as the Reproduction Value.

It is called reproduction because it is the amount a competitor would have to pay to obtain all of the required assets in order to be able to compete.

e.g. (Just using any wild number as an example) If I was to go through the balance sheet of Coca Cola and came up with an adjusted (reproduction) asset value of $100 with a market value of $300, an upcoming Pepsi will see that he only has to invest $100 to create an enterprise with a market value of $300. Just a crude example but I hope you get the point.

Earnings Power Value

The formula for Earnings Power Value is based off Graham and Dodd’s earnings assumptions that current earnings correspond to sustainable levels of distributable cash flows and earnings level remains constant. You will see that the formula also ignores growth. There is no variable for growth.

EPV = Adjusted Earnings x 1/R

where R is the cost of capital. The cost of capital can be a WACC or a simple discount rate assumption that I like to use.

EPV provides an intrinsic value by smoothing out earnings to ignore one time charges, resolve discrepancies between depreciation and amortization and capital expenditures, making adjustments based on the business cycle and other details which involves more hands on work.

Sounds simple enough, but you’ll have to work through the income statement to get a proper number for earnings.

When you arrive at an EPV for a company and if the value is lower than the reproduction value, you know that management is doing a bad job of using its assets to produce the level of earnings it should.

The second case is when EPV = asset value. This will occur in industries where there are no competitive advantages.

Lastly, if EPV exceeds asset value, you’ve likely found a company that has competitive advantages.

Take KO as an example again. Above I  mentioned that the asset value was $100 but the market value was $300. The difference of $200 is the competitive advantage it has over the competition. Pepsi may think it can reproduce the same type of results but the advantage KO has on the industry makes it virtually impossible to topple it off the top.

Value of Growth

Growth as a variable isn’t emphasized in the book as it leads to a lot of uncertainty but he goes on to discuss how growth can lead to economic destruction or added value.

This is because growth has to be supported by additional assets and to get those additional assets, you have to use the distributable cash which will reduce the value of the firm. If the company doesn’t have the competitive advantage, then the returns off the new investment will only be enough to offset the cost, effectively making it a zero gain.

Disadvantage of EPV

I like the fact that EPV doesn’t consider growth or too many variables but the one problem that I see with Earnings Power Value is that it uses earnings. While DCF has many variables, using the free cash flow numbers in my opinion will always be better than earnings.

e.g. Enron had great earnings all the way up to its collapse but FCF foretold the troubles long before the scandal surfaced.

But since the whole purpose of the book is to first go through the assets, followed by the EPV and then considering whether growth adds value, I would say it’s a solid stock valuation method.

Great Book to Study

The characteristic of great investing books is determined by the clarity of the examples and how well it leads the readers through the examples.

Value Investing: From Graham to Buffett and Beyond does a great job.

It goes through the 3 step valuation process for WD-40 and Intel in a very detailed step by step process. Definitely not a book you can read just once or without a pen and paper. It’s more like a mini-text book or a study guide to value investing but work through the book taking notes and highlighting key points and you’ll be on your way to mastering another great valuation method.

Also a good idea would be to go through the book with Bruce Greenwald’s EPV lecture notes on the topic. The diagrams and point form will help out in the understanding.

 

 

 

  • Floris

    thanks for the post. It has been on my list, but for some reason I have been hesitant to read something academic (as my background is academic finance, I know how stupid they can be). I’ll purchase it next time I order a lot of books on amazon. If you haven’t yet, the aggressive conservative investor is a great work on net asset value. It really clarifies this topic (and is written by a successful practitioner)

  • The chapters on the value investors are worth the read alone.

    Check out his latest video…http://www.youtube.com/watch?v=39so_a2qKEI&feature=player_embedded
    .-= Alex´s last blog ..Stocks On The Move 9.06.09 =-.

  • Jim

    Nice review Jae. I’d like to point out to FLORIS in case he/she didn’t know, Greenwald’s book was co-authored by Judd Kahn & Paul Sonkin; two very successful practitioners of the EPV method. I also want to point out that Bruce Greenwald is not only an academic, he is considered the “guru of guru’s” and one of the few professor’s of value investing that Warren Buffett makes special guest appearances in his class. I guess you can’t get any better of a “stamp of approval” than from Warren Buffett or Paul Sonkin.
    .-= Jim´s last blog ..Axcelis Tech. Update =-.

  • Jim

    P.S. Jae, I made an early mistake in my EPV calculation when I first brought up the EPV theory to you over a year ago (possibly 2 now: time goes by). I was deducting 1% from cash and the proper deduction should have been 1% deducted from sales (revenue).

    EX.

    Revenue = $100 Mill.
    Cash & Equivalents = $12 Mill.
    1% of Revenues = $1 Million.
    Cash & Equiv. – $1 Million = $11 Million.

    $11 Million is the amount to add back into the EPV along with deducting all interest bearing debt.

  • @ Floris,
    Thanks for the book rec. Will look into it. I do believe that Marty Whitman also makes several adjustments to the balance sheet but basically follows the principles of Benjamin Graham.

    @ Alex,
    I took the time to read the value investor section while I was on the plane but after a few pages, I still didn’t find much valuable info. Basically the same stuff as what I’ve read in countless articles and other books. Still good none the less.

    @ Jim,
    Didn’t know Buffett made guest appearances to his lectures. Very impressive. I do like Greenwald’s method of teaching and he obviously is a very smart guy. Wonder what his track record was/is like..

    When you first mentioned all the EPV calculations over a year ago, I didn’t understand it all but after reading the book, it’s a great learning tool.

    I’m currently in the process of adding an EPV valuation to the spreadsheet and I’m nearly done with the reproduction value section. Hope to get some more done and then I’ll send it over to you for your opinion and comments if you don’t mind.

  • Jim

    @Jae,

    I would love to take a look at the spreadsheet. I eagerly await your email. You do excellent spreadsheet work.
    .-= Jim´s last blog ..Axcelis Tech. Update =-.

  • Floris

    Hey Jim,

    I know he is quite respected (just look at the class recordings available at the schloss archive) and I will read his book. Call it availability bias that I ignored his book for this long.

  • Floris

    @Jae Jun

    Yes, he does. He especially takes into account long term assets that can easily be liquidated (prime real estate). The standard NCAV formula completely ignores real estate which has become much more liquid since the formula was first devised (at least until this crisis, but let’s assumes it will revert to the mean).

  • I starting reading this book two years ago, got half way through it, put it down and never got back to it. I saw it on my shelf the other day. I’m looking forward to reading it, though I’m going to check out at least one of the books you recommended that are a bit more elementary. Thanks for the post.

  • @ Floris,

    The upcoming spreadsheet in October will include a tab that allows you to adjust and value the assets, including long term assets and fixed assets.

    A more modernized and flexible method.

  • @ Todd,

    When I read the middle section alone, it’s about a 100 pages or less so it didn’t take long to read. I go through it on the plane to NY with lots of naps in between. :)

  • Jim

    Jae, pick up a copy of Greenwald’s other book “competition demystified”. I’m on my 3rd read. Its a very complex book and I wouldn’t recommend it to a new or relatively new analysts because of its complexities but it is a fantastic read. Its my 3rd read and its taken than many times to understand it and I’m sure I’ll read it a few more times. Basically, its a condensed version of Michael Porter’s works. Condensed in terms of being more concentrated for the value investor rather than a macro economist.
    .-= Jim´s last blog ..Axcelis Tech. Update =-.

  • Jay

    Excellent write up, Jae! I picked up this book about 6 months ago and am about half way through reading it. It is most definitely a book that you need to sit down with a pen and paper to truly understand.

  • J Mako

    I came to this review from review on Active Value Investing.

    I read this book too. At the time I thought it has a neat framework. However, I recently read in Lowenstein’s “The making of American Capitalist”, Greenwald himself admitted privately he was clueless on investing and it was speculation turned him on. (You can easily read those lines that by searching for “Greenwald” in the book content on Amazon.) That casts serious doubt on this book and whether it’s just pure intellectual/ivory tower work with no practical relevance.

  • jondz

    Hi, I’d like to ask a question with regards to EPV and growth. If you compare EPV with DCF, doesn’t EPV actually assume that your growth rate is the same as your discount rate, thereby making your current earnings also your future earnings? i.e. if your current EPS is say $50, discount rate 8%, and growth rate 8%, then PV of EPS 15 or ‘X’ years from now is still $50.

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