Earnings power value: what a business is worth with no growth

Earnings power value (EPV) answers a narrow question: what is a business worth if its current, sustainable profit simply continues forever, with no growth? It is a close cousin of the discounted cash flow, but it deliberately leaves out the hardest part, the forecast of future growth. The approach was popularized by Columbia professor Bruce Greenwald and his co-authors in their work on value investing.

The formula

EPV treats normalized profit as a perpetuity, a payment that continues indefinitely at the same level:

Normalized EBIT           = a sustainable level of operating profit
After-tax operating profit = Normalized EBIT x (1 - tax rate)
EPV (enterprise value)     = After-tax operating profit / cost of capital (WACC)
EPV (equity value)         = EPV (enterprise value) - net debt
EPV per share              = EPV (equity value) / diluted shares

The logic follows from the perpetuity formula. If growth is zero, the value of a steady stream of cash is that cash divided by the discount rate. The cost of capital is covered in WACC and the cost of capital.

Where the adjustments come in

The formula looks simple, and the work is in deciding what "sustainable" profit means. Practitioners usually adjust in a few places:

• Normalize the profit. Use average margins over a full business cycle rather than a peak or trough year. For cyclical companies this step matters more than any other.
• Remove one-offs. Restructuring charges, asset sales and legal settlements do not recur at the same level.
• Match depreciation to maintenance spending. If growth is zero, the company only needs to spend enough to keep its assets running. Reported depreciation can be higher or lower than that amount, so some analysts adjust profit toward maintenance capital spending. See depreciation and amortization and capital expenditure.
• Tax at a normal rate. Use a long-run tax rate instead of a temporary low or high one.
• Bridge to equity. Subtract net debt, and consider other claims such as leases, pensions or minority interests, depending on how your inputs were defined.

Example (illustrative numbers)

A company earns a normalized $200 million of operating profit (EBIT). The tax rate is 21% and the cost of capital is 8%. It has net debt of $300 million and 100 million shares.

If the shares trade well below $16.75, the market is pricing in a business that is worse than a steady no-growth version of today's profits. If they trade well above it, the extra price is a bet on growth, and the next question is whether that growth will create value.

The growth question

Comparing EPV with a full DCF value separates two things: the value of the existing business and the value of growth. Growth only adds value when the company earns more than its cost of capital on the money it reinvests. A business with a durable edge, which you can explore in economic moat explained, tends to have growth that is worth something. A business in a commodity-like industry may grow and add nothing, because each new dollar earns about its cost of capital. In that case EPV and the DCF value come out close.

How to read it

Treat EPV as a conservative reference point rather than a target. A rule of thumb is that a stock trading near or below a carefully calculated EPV is being priced as if it will never grow, which can leave a margin of safety if the business is stable. A stock trading at several times EPV needs growth to justify the price.

Common mistakes and limits

• Not a true floor. Calling EPV a floor is shorthand. Profits can fall permanently if technology, regulation or competition changes, and then the no-growth assumption is too generous.
• Sensitive to the cost of capital. A one-point change in WACC moves the result a lot, because the value is the profit divided by the rate.
• Normalization is judgment. Two analysts can pick different "sustainable" profits and get different values.
• Not suited to every business. Young companies with little or negative operating profit have no meaningful EPV, and banks and insurers need a different framework.
• Ignores the balance sheet beyond net debt. Unused cash, hidden assets and large off-balance-sheet obligations can all matter.

Where to see it on StocksXray

StocksXray shows earnings power value as a floor on a stock's valuation view. It is not blended into the fair value estimate, which is an equal-weight blend of three other models. Reading the two together shows how much of the fair value rests on growth rather than on current earnings. Because every valuation model carries a large error, see why fair value is a range.

Key takeaways

• EPV equals normalized after-tax operating profit divided by the cost of capital, then adjusted for debt.
• It values the business as it is today and strips out the forecast of growth.
• The hard part is deciding what profit is sustainable, especially for cyclical companies.
• Treat it as a conservative reference point, not a guaranteed floor.