Notes derived from Chapter 6 of Value Investing: From Graham to Buffett and Beyond
The search for distributable cash flows
The objective of earnings power value (income statement) analysis is to arrive at a reliable estimate of the no-growth average earnings power of the business in terms of cash flows which are free to be distributed to the owners.
The basic steps are as follows:
- Start with operating income (EBIT)
- Calculate taxes to be paid on operating income
- Adjust for one-time charges/gains
- Adjust for cyclicality
- Adjust for depreciation and amortization
- Adjust for maintenance capex
- Subtract taxes and interest
Calculating maintenance capex
There is generally a stable relationship within a firm between PP&E (net) and sales volumes.
Maintenance capex can be calculated by taking the ratio of PP&E to sales for each of five years and then taking the average. This is the dollars of PP&E required to support each dollar of sales. This ratio is then multiplied by the growth (or decrease) in sales for the current year to get growth capex. This number is subtracted from total capex and the remaining value is maintenance capex.
In order to calculate EPV, you need to be able to calculate the firm’s Weighted Average Cost of Capital, or WACC. You can approximate a WACC through the following steps:
- Establish the appropriate ratio between debt and equity financing for the firm.
- Estimate the after tax interest costs on the firm’s debt by comparing it with other firms.
- Estimate the cost of equity. For value investors not versed in CAPM, the best way to accomplish this is to make assumptions about what a firm would have to offer in returns to attract equity financing by surveying other fund-raisers (such as PE or venture capital firms). Another approach is to estimate total returns (dividends plus projected capital gains) that investors might earn from similar firms.
As the authors state,
The riskier the investment, the higher the cost of capital should be, but to say a great deal more with both confidence and precision is presumptuous.
Another shortcut would be to look at the interest rate on “risk free money” like a US bond and then add an appropriate premium compared to what other firms might be charged (in other words, is the company a better or worse risk than a US bond and if so, is it a little worse, a lot worse, etc.)
One final adjustment is necessary. The EPV assumes full equity financing of the capital structure. It should therefore be adjusted by subtracting the net debt (or adding the net cash) of the firm to the EPV.