Lesson 4 of 9
Earnings power value
Greenwald's method asks what a business is worth if it never grows again, which removes the assumption a discounted cash flow model gets most wrong.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Earnings power value asks what a business is worth if it never grows again, removing the input a cash flow model is least able to defend.
- It is built in three tiers, in order of reliability: what the assets would cost to reproduce, what current earnings are worth capitalised, and only then the value of growth.
- A gap between the second tier and the first is a franchise only if it survives a second look at how the reproduction estimate was built.
Earnings power value asks what a business is worth if it never grows again. That restriction removes the input a discounted cash flow model is most sensitive to and least able to defend, starting from figures a company has already filed.
Reproduction value, and the earnings power above it
What earning power adds
- Franchise gap · 12.9% of reproduction value; earnings power value is 1,185$13511%
- Asset reproduction value$1,05089%
What the assets cost to reproduce
Total$1,185
Tier one: what the assets would cost to reproduce
Bruce Greenwald's method, set out with Judd Kahn, Paul Sonkin and Michael van Biema, starts from reproduction cost, not book value: what a competitor would spend today to build the same productive assets. Property at depreciated historical cost is written up to today's cost: in the worked example below, that write-up is 200 of the 1,050 total. Goodwill from past acquisitions comes out, because a new entrant does not pay somebody else's purchase premium. Spending the accounts never capitalised, research and the customer base built by past marketing, goes in, because a competitor must fund it too.
Tier two: capitalise normalised earnings
Take operating margin over a full cycle, not the latest year, and apply it to current revenue. Strip one-off items, correct depreciation to what the business actually needs to spend to stand still, tax it at a normal rate, and capitalise with no growth term.
This is the value of the operations. Add excess cash and subtract debt to reach the equity.
Nothing here is a revenue forecast or a terminal growth rate. The only estimates are the normalised margin, maintenance capital spending and the cost of capital, and each can be argued about on its own.
The franchise test
Compare the two tiers. Earnings power value materially above reproduction value means the business earns more than the cost of the assets it uses, and that gap has to be explained by a barrier to entry or it gets competed away.
A gap of 12.9 percent of reproduction value is inside the error of the reproduction estimate itself. Halve the property write-up, from 200 to 100, and reproduction value falls to 950. The gap becomes 235, or 24.7 percent: nearly double, from one judgement. A franchise gap has to survive being computed twice, at both ends of the adjustments you would defend, before it counts as evidence of anything.
Why growth comes last
Greenwald's argument is that growth inside a competitive business earns exactly the cost of capital and creates no value: the company invests a dollar, earns what the dollar cost, and shareholders are where they started. Buffett reached the same place in the 1992 letter: growth is an input to value, not an alternative to it, and its contribution can be negative. Growth is added only to a business that already passed the franchise test, and it is the least reliable of the three tiers.
Check yourself
Why does earnings power value use reproduction cost rather than historical book value for the assets?
- Reproduction cost is always lower
- It answers what a competitor would have to spend today to enter, which book value at historical cost does not
- Book value is not available in filings
Show the answer
Answer: B.
Book value reflects what was originally paid, often decades ago. Reproduction cost asks what building the same productive capacity would cost a new entrant today.Earnings power value is 1,185 and reproduction value is 1,050. What does that 135 gap suggest, on its own?
- The business is definitely worth more than its price
- A possible franchise, only if the gap survives a second, more conservative estimate of reproduction cost
- Nothing; the gap is always noise
Show the answer
Answer: B.
A gap this size is inside the error of a reproduction cost estimate. It becomes evidence of a franchise only once it is checked against a more conservative set of assumptions and still holds up.In Greenwald's method, why is the value of growth estimated last, after the first two tiers?
- Growth is never valuable
- Growth only adds value at a business that has already shown a franchise; without one, growth earns just its cost of capital
- Growth cannot be estimated at all
Show the answer
Answer: B.
Growth inside a business with no barrier to entry earns the cost of capital and adds nothing. Valuing growth first, before checking for a franchise, anchors a valuation on its least reliable number.Sources
- Greenwald, Kahn, Sonkin and van Biema, Value Investing: From Graham to Buffett and Beyond, 2001, on reproduction cost, earnings power value and the franchise test.
- Berkshire Hathaway shareholder letter, 1992, on growth as an input to value that can subtract as well as add.
- Berkshire Hathaway shareholder letter, 1986, appendix, on owner earnings and maintenance capital expenditure.
What this leaves out
- The method assumes current earning power is sustainable, which is false for a business in secular decline, where it returns a figure that is too high.
- Reproduction cost has no filed source. Every line in it is a judgement, and the worked example shows one judgement moving the franchise gap by nearly a factor of two.
- Maintenance capital expenditure is not a line any company reports; any earnings power value carries the reader's own estimate of it.
- ValueScreener does not compute or store earnings power value. Nothing here is advice about any security.