Dubai: While it’s apparent investing in stocks often involves quite a bit of analysing, especially when it comes to monitoring metrics like valuation or earnings growth, putting your money in share markets also allows you to form an opinion about how the businesses will perform in the future.
“When looking to make profits by buying stocks, don’t leave it to chance like many investors often do, but instead rely on getting gains based on the strength of the businesses backing those stocks,” explained said Zubair Shakeel, a UAE-based asset manager.
Stocks are a fractional ownership interest in a business, and as the business performs well or poorly over time, the company’s stock is likely to follow the direction of its profitability. By investing in stocks, you not only own an indirect stake in the business, but also in its capability to earn profits.
“Even though stocks have inherently been volatile, they’re based on the earning power of businesses. As earnings rise, so will stocks, at least over time, as opposed to cryptocurrency, which usually have no basis – such as earnings or hard assets – to back their valuation,” Shakeel added.
Most often, prices gets set by the action of buyers and sellers, because of which stocks get unrealistically pumped up or held down by unwarranted concerns. The prices get out of sync compared to the actual financials the company yields.
‘Earnings power’ signifies future growth capacity
Created by renowned US investor Bruce Greenwald, ‘earnings power’ value attempts to determine the fair value for a stock based on its current earning power based on what the firm's financial statements currently indicate, while disregarding any unfounded price spikes and plunges.
So the ‘earnings power’ value of a stock is essentially a method used to find out the intrinsic value of a company's stock and it represents a figure that summarises a business's ability to generate profits over the long haul.
‘Earning power considers metrics such as a company's return on assets (ROA), which is the ability to generate profit from its assets, as well as the return on equity (ROE), which is a measurement of a stock’s financial performance.
This is why analysts ritually assess a company’s earning power when issuing buy and sell recommendations to best determine if a company’s stock is worth investing in. However, keep in mind that ‘earnings power’ assumes that ideal conditions will continue to surround the business.
The ‘earnings power’ value is a metric used to determine if a company's shares are fairly valued, overvalued, or undervalued
How to calculate ‘earnings power’ value of a stock?
Also, ‘earnings power’ does not account for anything that may negatively affect rates of production. Therefore, there is an ever-present risk that general market volatility, regulatory restrictions, or other unforeseen events may affect business flows in ways that earnings power cannot anticipate.
“The ‘earnings power’ value is a metric used to determine if a company's shares are fairly valued, overvalued, or undervalued, and its formula is used to calculate the level of distributable cash flows that a company could reasonably sustain,” explained Shakeel.
“Current earnings are used, rather than forecasts or discounted future earnings, since current earnings are more dependable than other valuation metrics which rely on assumptions or subjective evaluations.”
The basic earning power ratio formula is simple and takes the profit figure, which includes all incomes and expenses but excludes interest expenses and income tax costs, and divides it by total assets a company has.
Mistakes made when calculating ‘earning power’?
“A company with a higher ‘earning power’ ratio is more efficient at generating income from its assets. The greater the ratio's value, the greater the profitability created from the assets of the company,” explained Brody Dunn, an investment manager at a UAE-based asset advisory firm.
“However, a great company with a high ‘earning power’ ratio and a great investment are two different things. The seminal factor is the price paid, and barely profitable companies can be much better buys than very profitable companies,” he added. “This is the error that most people make.”
Also, Dunn further noted that by excluding the interest expense, you disregard debt. This could lead to concerns if the company has large amounts of debt, which is “something best avoided”.
“While it’s not a perfect predictor of fair value, the technique is really useful for quickly getting a sense of the risk of investing in a company at the current price. With a few assumptions, you can quickly determine if a company justifies further research,” said Dunn.
While it’s not a perfect predictor of fair value, the technique is really useful for quickly getting a sense of the risk of investing in a company at the current price
Key takeaways
In order to answer the question: How efficiently does the company turn invested money into profit? – It’s useful for an investor to learn that ‘earnings power’ value represents the ratio of a company's earnings to its cost of capital.
You can see whether the stock price is low compared to its current ‘earnings power’, which suggests that the stock is undervalued and will eventually go up, or whether it is too high, suggesting the stock is overvalued and will eventually go down.
Investors should favour a company with a higher ‘earnings power’ over a company with a lower ‘earnings power’ because that means it extracts more value from its assets, but they still need to consider how things like leverage and tax rates affect the company.
As the above approach depends on the company’s ability to maintain constant profits and helps disregard any unwarranted price fluctuations, it provides a more reliable indicator for investors to buy a worthwhile stock instead of leaving it to chance and blindly hope if the stock would rise or not.
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