There are several steps required to calculate EPV:
1. Normalization of earnings is required to eliminate the effects on profitability of valuing the firm at different points in the business cycle. This means that we consider average EBIT margins over the past 10, 5, or 3- years and apply it to current year sales. This yields a normalized EBIT.
2. Subtract the average non-recurring charges over the past 10 years to the normalized EBIT.
3. Add back 25% of SG&A expenses to, as a certain percentage of SG&A contributes to current earnings power. We use a default add back of 25%. This assumes that the company can maintain current earning's with 75% (1-input) of SG&A. The input range can be 15-25% depending on the industry. Where applicable, repeat for research and development expenses.
4. Add back depreciation for the current year. We use a default add back of 25%. This assumes that the company can maintain current earning's with 75% (1-input) of capital expenditures. The input range can be 15-25% depending on the CapEx requirements of the industry.
5. Subtract the net debt and 1% of revenues from normalized earnings (this is an estimate of cash required to operate the business)
6. Assign a discount rate (or calculate WACC if you wish).
7. Earnings Power of Operations = Earnings of the firm * 1/cost of capital
8. Divide the EV of the firm by the number of shares, to get Price per share.
The DCF stock valuation model.
In this 3-stage DCF model, free cash flow growth rates for years 1-5, 6-10, 11-15, and the terminal rate, are estimated. The sum of the free cash flow is then discounted to the present value.
The formula for a DFC model is as follows:
PV = CF1 / (1+k) + CF2 / (1+k)2 +... [TCF / (k - g)] / (1+k)n-1
• PV = present value
• CF1 = cash flow in year I (normalized by linear regression or 10, 5, 3-yr average of FCF)
• k = discount rate
• TCF = the terminal year cash flow
• g = growth rate assumption in perpetuity beyond terminal year
• n = the number of periods in the valuation model including the terminal year
Again, we must recognize that intrinsic value that is produced by our model is only as good as the numbers put into the model. If as part of our stock research we assume unrealistic growth rates (or terminal value), or discount rates, you will get an unrealistic intrinsic value result. No stock valuation model is going to magically provide the completely accurate intrinsic value but, if you are conservative and intellectually honest, and dealing with a company with solid underlying economics in addition to a long track record, you can find this method useful in identifying stocks that are priced below their intrinsic value. Buffett seemed to do OK for himself using this methodology so, if you follow the above principles, you can too.