Share valuation using Earnings Power Value

[TheMotorcycleBoy]

So now I am researching the share valuation technique known as "Earnings Power Value" (EPV). After spending sometime googling, and uncovering several differing documents/blogs I decided to invest in this book and hence I'm largely basing my workings on what I've gleaned so far from this.

As a little bit background EPV is cited as being a more trustworthy technique, than techniques like Discounted dividends and discounted cash flows, since both of those techniques rely on estimates of future growth, which of course is hard to predict, where as EPV looks only at figures reflected the company's financial position from the present and the recent past. Indeed a fundamental aspect of this model, is to assume no growth, and to determine a "distributable cash flow" that be obtained from the company at the current time.

Again from the book mentioned above, this is my summary of the technique:

1. Allowance for one-off events, with consideration mainly focused on "current earnings" i.e. those reported most recently; consider several years prior, e.g. the last 4 years and get an impression of what cost charges described as exceptional really are, and make an adjustment for these. For example suppose the firm was sued this year by an injured customer/employee/organisation, and the sum has reduced the profit e.g. by 12%. If this is not a regular occurrence then this sum should either by added back onto the profit, or the assumed to occur "every 10 years or so", and then only 1/10 of the reduction made to the "adjusted earnings".

2. Since the model assumes no growth (since future growth is perceived as being a speculative forecast), any costs which the company has borne regarding expansion e.g. a portion of R&D, Marketing etc. is added back. In other words if the company is growing at 10% then it seems reasonable to add back 10% of these costs back to the adjusted earnings since this money would not be getting spent if the company was not attempting to sustain a given level of growth.

3. Adjustments made due to amortisation, depreciation and capex. Firstly capex is split into maintenance capex and growth capex, and the "growth capex" figure is removed from the costs, again since the model desires currently distributable cash flow. Since reported A&D and capex may vary from year to year, ratios of A&D/sales and maintenance capex/sales are calculated over several years and averages are found. Hence the average A&D/sales and maintenance capex/sales figures enable us when is possession of the current sales figures to arrive at more realistic values, in the case of A&D to add back and in the case of maintenance capex to subtract.

4. Take account of cyclical fluctuations i.e. average out good and bad years.

After making these adjustments to the most recent reported earnings, we work out the "earnings power value" of the company producing the earnings and thus the value of it's equity by considering what happen if a tycoon was about to front such this kind of money in expectation of annual earnings in the order of those our adjustment process has just assumed. Hence if the tycoon put down this money he/she would expect a rate of return (cost of capital) and if realised this would result in the adjusted earnings just calculated. In other words:

rate of return = annual distributable cash flow/value of investment

and hence after rearrangement of terms, and labels:

equity value = annual distributable cash flow/rate of return

and division of the number of shares in the market for the company we are evaluated give us our hypothetical share value.

In my next posts I will try to apply this to the company Marshalls PLC (MSLH)

Matt

[TheMotorcycleBoy]

Here are main figures I used to start of doing the EPV on Marshalls. Out of interest they are available here.

All figures except years, rates, and % are in £1000s				
					
	            2013     2014      2015	 2016	2017
Sales	          307390   358516    386204    396922 430194
Growth since last  ...      51126     27688     10718  33272
EBIT	           16090    25305     37452	47639   3439
Tax rate%           19.2     18.7      20.9      18.5   19.1
Unadjusted PAT     13001    20573     29625	38826  43232

Further note that only sales, costs and taxes, are of certain in the above - the model ignores finance (i.e. interest) gains and losses. Also I can state that there was nothing in Marshalls P&L in the way of exceptional items to have to account. So what I then did was reconcile amoritisation, depreciation and capex over the last few years in order to figure how much to add back / subtract from earnings figures.

*               2013     2014      2015	 2016	2017
Deprec.	       13455	11982     13054 12146  13314
Amoritisation    938	 1231      1322  1009   1142
Total A&D      14393	13213     14376	13155  14456
Total capex    -6058   -12010    -14925 -13873 -20645

The first thing I did with the above data is to figure out what proportion of capex is used to maintain existing assets:

*               2013     2014      2015	 2016	2017
Capex/sales	0.02	0.03       0.04  0.03   0.05

We can then note that on average 3.5% of sales £ is spent of capex per year. Since from 2016 to 2017, sales grew by 33272, we can assume that about the cost of financing this growth in terms of capex was approximately:

0.035 * 33272 = 1165

Hence for 2017, 20645 - 1165 = 19480 was maintenance "stay in business" capex.

In similar way, that is:

*               2013     2014      2015	 2016	2017
A&D/sales	0.05     0.04	   0.04	 0.03	0.03

I noted that the average A&D per year is about 3.8% of sales. Thus the adjustment to make against 2017 calculations would be 0.038 * 430194 = 16347.

So given the above I think that it is reasonable to add back A&D of 16347 and subtract away 19480 (000s) from our adjustment calculations so far.

[TheMotorcycleBoy]

Now I tried to figure how much of Marshalls "real costs" i.e. not A&D should be added back, since they are present to finance growth, and as the EPV model just looks at "distributable cash flow" with no growth.

Firstly looking at sales growth from 2013-2017 and using CAGR, I calculated

(430194/307390) ^ 0.25 - 1 = about 9%

I looked at Note 3. Operating costs page 89 and decided it was too simplistic and probably overly generous to merely decide to add back 9% of the total 376,755. So I looked at various entries. It's obvious, in my opinion, to add this back:

Acquisition costs 837

but not so with materials and personnel costs. Despite the fact that one could maintain extra staff being employed and indeed raw materials to ramp up production (?). So in addition the acquistion costs, I'm going to add back 9% of this entry:

Other operating costs 106,569

since presumably these entry serves as a bucket for sales&marketing, R&D costs.

So costs to add back 837 + 0.09*106,569 = 10428.

[TheMotorcycleBoy]

Now to start actually building up the adjusted earnings, first I planning on adding back the portion of the costs which I determined in my last post i.e. straight back to EBIT. Then I ummed and ahhed about whether to add A&D - capex back before or after tax. My personal view would be to add these back before tax but the book I mentioned in my OP, in it's worked example for WD-40, applied these adjustments after tax, so that's what I will do for now. However, I'd appreciate any other suggestions/advice from people with an accountancy background as to the best way of handling these.

So here goes:

Year                                       2017
Sales                                    430194
EBIT                                      53439
Add back acquisition costs                  837
Add back 9% of sales/marketing/etc. costs 10428
Adjusted EBIT                             64704
After taxing at 19%                       52410
Add back average A&D                      16347
Reduce by average maintenance capex      -19480
Adjusted PAT                              49277

[TheMotorcycleBoy]

The final I did prior to arriving at the figure for distributable cash flow, was see what net cash might possibly be in the organisation which could thus be added to this cash flow. It is tempting to consult only the current assets and liabilities and discover:

Cash 19,845
Short term debt 35

and derive a residual cash outstanding value of 19,810. However, earlier in 2017, Marshalls financed the acquisition of CPM for a cost of £41million. Although this debt is long term, a portion of it is payable within a year's time (note 15 on page 100). This suggests that 244+14665 of the above cash is basically accounted for. Perhaps it's a moot point, whether to offset Marshall's cash position with this obligation? Since debt can be refinanced/scheduled etc. However for a conservative estimate, I'm going to settle on Marshall's net cash position being:

19845 - (35 + 244 + 14665) = 4901

So adding this value to the value of 49277 for adjusted earnings gives 54178 as a possible figure for the distributable cash flow.

[TheMotorcycleBoy]

Finally to calculate the Equity value attributable to this "earnings power", I divided by a value for the cost of capital the distributable cash value of 54178 I've just calculated.

@7% = 773971
@8% = 677225

then divide by 198902 (000s of) shares, remembering all my £ figures are also in 000s, to arrive at £3.89 and £3.40 EPV per share respectively.

Whilst these figures are of course slightly out of date, since Marshalls will release their next Annual report this December, I believe; and their earnings (if the half year results are anything to go by) may well be higher then. However, this exercise is interesting to perform, and of course now I have figured this out once it will straightforward to apply to others, in order to attempt to derive a feeling of "Intrinsic value".

Any comments, criticisms etc.? Given that the market price of the share sometime this week was £4.15, what conclusions regards this model can be drawn?

Matt