Do You Know The Economic Book Value (EBV) of Your Investments?
It’s All About Economic Book Value
In my previous blog, I discussed how GAAP (Accounting) earnings can distort economic earnings and how using the former to calculate P/E ratios can lead to distortions in valuation. Today, I’ll describe a single metric that should be the gold standard for determining value in publicly traded stocks. It’s economic book value (EBV). This metric takes into account the true earnings power of a business, normalized to its cost of capital in an environment of no value-added growth (i.e. ROIC = WACC). It is adjusted for non-operating assets and liabilities, including all claimants on total value. EBV is a crucial metric to compare with the stock price of publicly traded companies.
Calculating EBV
The generic formula for EBV is
(NOPAT/WACC) + non-operating net assets – claimants value.
It is a simple formula but complicated to calculate. The calculation of NOPAT requires adjusting GAAP earnings into Net operating Profits After Taxes (NOPAT). Non-operating net assets need to be identified as a source of value. They can include excess cash, unconsolidated subsidiary assets, net assets from discontinued operations, net deferred compensation assets and net deferred tax assets. Claimants value also needs to be calculated. They can include debt holders, employees, retirees, preferred shareholders, minority interests and even the government. All claimants are entitled to their share of company value with the remainder assigned to common equity shareholders.
Why Companies Are Often Mis-Valued
In most circumstances, investors do not correctly value businesses because they
- Fail to accurately determine the true economic earnings of the business.
- Do not properly distinguish between assets that are used in the operations of a business and those that aren’t.
- Fail to account for all claimants who are entitled to their share of business value.
Making Money by Identifying Stocks Priced Well Below Their Economic Book Value
Ultimately, money is made by identifying and investing in companies that are priced well below their economic book value. However, determining economic book value is a difficult task that requires deep analysis and cannot be obtained by watching financial entertainment channels, prognosticating equity markets or analyzing technicals. At QMI Capital, we invest in and utilize resources that provide the deep analysis needed to quickly and accurately value businesses. Then we like to buy those businesses at a discount and wait for the market to discover the price/value gap. It happens a lot more than you’d think in a world where most believe that markets are efficient. Until next time…