Earning power is the single most important factor in our valuation of a company and the key focus of our analysis process. The purpose of our analysis is to arrive at a figure that represents the distributable cash flow that the owners of the business can extract while leaving the operation of the business intact. Only companies that generate more cash than they consume add shareholder value over time. For more than ten years our primary focus has revolved around analyzing and understanding the earning power of the businesses we may invest in. The concept of earning power is not an exact science or even a term that is clearly defined in the investment world. Despite the passing of seventy years since Benjamin Graham first developed the concept — a concept that is central to the valuation of any business — it still appears to be somewhat elusive to many equity investors. At EVP earning power is ingrained in us and is crystal clear.
How we define earning power
We define earning power as the amount of discretionary free cash flow a company generates over a business cycle.
We prefer to work with cash flow rather than earnings. We consider cash flow to be a superior measure of the economic success of a business compared to accounting earnings. Cash flow does not, however, have a single definition in the investment world.
As equity investors we are primarily interested in economic profit that can be distributed to the shareholders of the business. Therefore the relevant figure is the discretionary free cash flow. To be more precise, it is the normalised operating cash flow generated by the business less maintenance capital expenditure required to continue its operation. This is the cash flow available to shareholders after the company has made the investments into the business that are required to keep its existing production or services going. Management can choose to pay out dividends, reduce its debt burden, make investments to expand its business, acquire other companies or buy back its own shares in the stock market. All five actions benefit shareholders, provided management applies sound judgment.
It is important not to base the valuation on any single year, but to take a longer period of time into account to avoid the distorting impact of the business cycle on individual years. We are not looking for the simple average earnings over the business cycle but for an average that represents the "normal" and inherent permanence of earning power. For this reason we do not look at one particular year in isolation, but want to understand what earnings this business has generated in the past and may continue to generate in the future. Any private or corporate buyer would not simply base their valuation on one single year, but will take into account the impact of the dynamics of a business cycle. |
