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Since the rise of the internet, anyone with access to a computer, and now a mobile phone, can blog or vlog just about anything.

Globally, this has given rise to a number of people teaching others how to invest in the share market.

Before the internet; newspaper editors, radio producers, book publishers and TV producers were the gateway, which held back or promoted people, who wanted to teach investing to the general public.

This gateway served a useful purpose, as most of the time it filtered out those who weren’t qualified to speak or who are bat shit crazy.

The internet blew off the doors to this gateway, creating in effect, a large market place of ideas in the internet sphere.

This market place of ideas is also useful in filtering out those who know what they are talking about compared to those who think they do.

In the market place of ideas; no idea or mental model, is off-limits, nor should they be. Every idea, we as Bloggers and Vloggers place out in this market place, is and should be, subject to critique.

Especially, considering that the advice we are providing could result in severe consequences for the person listening and acting upon our advice.

And, one idea used in practice by value investors, that we need to critique, is the Earnings Power Value concept. In this article, we will look at why parts of the equation need changing, and in doing so, how it would better suit your needs.

What is EPV?

And the formula looks like this:

EPV = Adjusted Net Earnings X (1 / Cost of Capital)

Bruce Greenwald summed up why this formula is important:

The second most reliable measure of a firm’s intrinsic value is the second calculation made by [Benjamin] Graham and [David] Dodd, namely, the value of its current earnings, properly adjusted. This value can be estimated with more certainty than future earnings or cash flows, and it is more relevant to today’s values than are earnings in the past.

Whereas, the Discounted Future Cash Flow (DFC) formula relies solely on estimating future cash flows, which incorporates our own research and bias about the ability of the company to produce future cash flows.

And, if the company has no competitive advantages, which allow the company to grow revenues and earn high rates of returns on capital, then you are wasting your time and increasing the risk of losing money.

The only issue I have with Greenwald’s EPV formula is the use of the Cost of Capital, which I believe hampers the investor’s ability to gain clarity in forming a confident EPV of the company, and prevents us from earning high returns on their investments.

 Cost of Capital Vs. Require Rate of Return (RRR).

The cost of capital is knowable but not notable.

What I mean by this is that the cost of capital is an important concept to understand, but implementing it in to practice causes more troubles than what it is worth.

For instance.

The cost of capital is the weighted average of the company’s rate of interest paid on debt and required return demanded by investors for a share in the company’s equity.

So the cost of equity to the business owner is your required rate of return.

And, the cost of debt to the business owner is the interest rate on debt demanded by the lender, be it a bank or corporate bondholder.

We can safely ignore the interest rate a company pays on its debt pile in this case, because we already account for it in process of evaluating the asset and liability values on the balance sheet, which is step three in the Share Investors Blueprint.

And, because we are looking to invest in the highest quality businesses that earn high rates of return on capital, then these businesses will have little to no debt.

Because the cost of equity to the business owner is the rate of return we demand as investors, then it makes sense to apply our required rate of return, which is the same rate of return we want our investments to compound at!

Warren Buffett famously quipped that;

When a business manager approaches me for funds for a project, I simply charge them 15 percent – that usually gets their attention.

Warren Buffett

Think of it this way.

For every dollar invested, how much do you want to earn back at a bare minimum?

10 cents – 10%?

15 cents – 15%?

20 cents – 20%?

25 cents – 25%?

If we demand at a minimum 10 percent, then the EPV formula becomes…

EPV = Net Adjusted Earnings X (1/0.10)

The two main advantages are:

You know with certainty that you are earning a 10 percent yield on your investments if you buy shares at the EPV per share, and if the share price fall below EPV per share figure than the yield you earn increases!

Secondly, as the company’s net earnings grow, so does the yield on your original investment. Which also applies to the dividend yield.

What about the Equity Risk Premium?

According to the financial media, the ERP is approximately sitting at the 6 percent mark.

Is this an acceptable rate of return for you?

The ERP is the markets, as a whole, required rate of return (discount rate), I question whether how applicable to us individual investors, who are selecting stocks on an individual basis, the ERP is?

While it is still important to understand the role and effects the ERP plays on the stock market, for instance, Roger Montgomery @ Montgomery Investment Management believes that the variance between ERP and the rate on risk-free assets – Government Bonds –  will converge closer together over the coming months, which will drive the valuations of stocks a lot higher.

But on an individual stock selection basis, ERP can be ignored.

Adjusted Net Earnings Vs. WB Owner Earnings

The method Greenwald uses to calculate the Adjusted Net Earnings figure, is really insightful and I encourage you to apply it.

But, sometimes due to lack of financial data or time limits, I find it just as acceptable to use Warren Buffett’s Owner Earning’s calculations as an alternative.

I am not advocating that you switch, but consider using it, especially as an alternative when doing a back of the envelope calculation.

In case you don’t know what WB OE formula is, it is this:

OE = Net earnings + Depreciation & Amortisation – Capital Expenditures.

Case study: CSL

If we apply all of the above into CSL 2019 net earnings per share, substituting Warren Buffett’s Owner Earnings, then the formula looks like this:

WB OE = 4.23 + 0.828 – 2.46

            = $2.60

EPV = $2.60 x (1/0.10)

      = $26

The $26 dollar EPV of CSL is a far cry from CSL’s share price of over $300 dollars.

But, as CSL operates with strong competitive advantages, allowing it to earn high rates of returns on capital and grow revenues at 7.3%, then I would highly recommend you move to the next step and calculate the DFC valuation of CSL in 5 and 10 years’ time.

Back in July 2019, you could have brought Adairs (ASX.ADH) at $1.42, which was 29% below the EPV at $1.83 per share.

Over the next 6 months, the market responded to the undervaluation, rewarding shareholders with a 64 percent return!

Yahoo Finance

At the time, I wrote in the book….

The EPV is 29 per cent above the share price, which is the perfect time to buy. You get the current earnings at a discount, significantly reducing the risk of loss, and you pay nothing for growth! Plus, dividends are the cherry on top.

At the current share price, the earnings yield works out to be 13 per cent! Also, you are earning a fully franked dividend yield of 6 per cent.

Additionally, there is a prospective 37 per cent CAGR over the next five years, with a prospective 22 per cent CAGR over the next ten years.