Earning Power

Earning Power is a company's estimated sustainable profit from its current operations, smoothed out over an entire business cycle. Think of it as the true, underlying profitability of a business, stripped of any accounting quirks, one-off events, or the short-term ups and downs of the economy. While reported annual profits can swing wildly, Earning Power aims to answer a more fundamental question: “If this company were to operate in a 'normal' year, how much money would it consistently make before considering growth?” This concept is the bedrock of value investing, championed by legends like Warren Buffett. It forces you to look past the noisy, often misleading quarterly reports and focus on the long-term, durable profit-generating capacity of the business itself. It’s not about what a company did earn last year, but what it can earn, year in and year out.

Imagine you’re buying a local pizzeria. Would you base your purchase price solely on its profits from last week, which happened to be during a massive city-wide festival? Of course not. You’d want to know its average weekly profit over a whole year to account for both busy and slow periods. Earning Power applies the same logic to publicly traded companies. Reported Net Income, the figure you see at the bottom of an income statement, can be a poor guide to a company's true health. It can be temporarily inflated by selling a factory or artificially depressed by a one-time restructuring cost. Earning Power cuts through this noise. By focusing on normalized, operational earnings, it gives you a much more stable and reliable starting point for figuring out what a business is actually worth—its intrinsic value. It helps you avoid overpaying for a company enjoying a temporary boom or foolishly selling a great business suffering a temporary setback.

Here's the fun part. Calculating Earning Power is more of an art than a precise science; it requires judgment. There isn't a single formula plugged into a Bloomberg Terminal, but the method taught by Benjamin Graham and his followers provides a fantastic framework.

The goal is to find a representative level of operating profit and then apply a representative tax rate. The most common starting point is Earnings Before Interest and Taxes (EBIT), as it shows a company's profitability before the effects of debt and taxes, giving us a clean look at the business's core operations. The simplified thought process looks like this: Normalized Operating Earnings x (1 - Normalized Tax Rate) To get there, an investor typically performs a few key adjustments:

• Average the Earnings: Look at the company’s EBIT over a full business cycle, usually 7 to 10 years. This smooths out the peaks and troughs of the economy.
• Normalize for One-Offs: Scour the financial statements and remove any non-recurring or extraordinary items. Did the company have a massive gain from selling a division? Remove it. Did it have a huge write-down from a failed project? Add it back. The goal is to see what the business earns from its ongoing activities.
• Use a Normal Tax Rate: Instead of using last year's effective Tax Rate, which can be skewed by various deductions or credits, use a long-term average or the current statutory corporate tax rate for the company's home country. This provides a more sustainable figure.

Let's look at “CycleCo,” a fictional bicycle manufacturer. Here is its EBIT for the last five years:

• Year 1: €10 million
• Year 2: €12 million
• Year 3: €25 million (Sold an old factory for a €15 million one-time gain)
• Year 4: €8 million
• Year 5: €11 million

A naive look at Year 3 suggests a fantastically profitable year. But as a smart investor, you see the one-time gain. To normalize Year 3's earnings, you subtract that gain: €25m - €15m = €10 million. Now, your normalized EBIT figures are: €10m, €12m, €10m, €8m, and €11m. The average of these is: (€10 + €12 + €10 + €8 + €11) / 5 = €10.2 million. This €10.2 million is our estimate of CycleCo's normalized operating earnings. Assuming a normalized tax rate of 25%, we can calculate its Earning Power: €10.2 million x (1 - 0.25) = €7.65 million. This €7.65 million is a far more realistic estimate of the company's sustainable profit-generating ability than the reported net income from any single year.

This is the core distinction. Net Income is what the company reported it earned according to accounting rules for a specific period (e.g., the last quarter or year). Earning Power is what an investor estimates the company can sustainably earn in a normal year going forward. One is a snapshot, often blurry; the other is a carefully developed, long-exposure photograph.

Free Cash Flow (FCF) is another top-tier metric for value investors, representing the actual cash a company generates after all expenses and investments in its future. In a stable, mature company that isn't growing much, Earning Power and FCF should be very similar over the long run. However, for a company that is growing, FCF can be low or even negative because it is spending heavily on Capital Expenditures (CapEx) to fund that growth. In this case, Earning Power can be a better tool. It reveals the underlying profitability that is being reinvested. It shows you the powerful engine that, once growth slows, will begin spewing out immense amounts of free cash flow.

Earning Power isn't just an academic exercise; it's the foundation for a rational valuation. Once you have a conservative estimate of a firm's Earning Power, you can calculate its Earning Power Value (EPV) by simply dividing the Earning Power by its Cost of Capital. This gives you a no-growth, steady-state valuation of the business. By comparing this EPV to the company's current market price, you can quickly see if it's potentially undervalued. Mastering the concept of Earning Power helps you tune out market noise, ignore Wall Street's short-term hysteria, and focus on what truly matters: the long-term, durable profitability of the business you are hoping to own a piece of.