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Discussion in 'Trading' started by jjk2, Nov 5, 2008.

1. ### jjk2

i'm reading the book, beyond graham and dodd,

I have a question about Earnings Power Value

EPV = Adjusted Earnings * (1/R)

where R is the cost of capital.

how do you calculate R ? do i just use the risk-free rate and add 1 or 2 points to it? it talked about Weighted Average of Cost of Capital, but not certain how you go about determining this company.

Also, when market cap / adjusted book value ratio is near 1 or 2, would this indicate a buying opportunity ?

thank you!

also, the book has an Intel example, where they are choosing to add 25% of Depreciation & Amortization, R&D, SG&A, i'm wondering when would you know to add all 100% of the items above, and when you should add a portion of it, when adjusting the book values. would you add a portion of the items mentioned, when you find that the company's EPV is bigger than book value ???

note: i'm thinking that this forum is more geared towards trading, if someone could recommend a good community for value investing, i would appreciate it! thanks!

2. ### AAA30

The weighted average cost of capital is calculated by
D/(D + E) Ã 1/(1 - t) ÃRd + E/(D + E) Ã Re = WACC
D= dollar value of debt
E= market cap(Market equity value not Shareholders equity)
t= tax rate
Rd= cost of debt
Re= cost of equity

Re is calculated using CAPM

3. ### jjk2

so debt would be all of the current and long term debts added together? what about the cost of debt, and cost of equity how do you find those ?

it seems like the book, they were just grabbing numbers out of air but saying that they were not....there was one page that explained how they justified teh Cost of capital for WD-40 being 8 percent, which is risk free rate at that time + extra points.....

this was not so clear.

4. ### AAA30

Don't add current debt unless it is large or is rolled over fequently so just worry about LT debt . If the current debt is large or is kept large normally add it into the formula I gave you and times it by its weight in the total capitalization.(Updated formula is below)
Dc/(Dc + DL + E) Ã 1/(1 - t) ÃRc + DL/(Dc + DL + E) Ã 1/(1 - t) ÃRdL + E/(Dc +DL + E) Ã Re = WACC
Dc = current debt DL= long term debt

The cost of debt is the current rate that the company could borrow at in the market. If you can not find the actual bonds just use a benchmark rate for their credit rating or the bonds of a comparable company. For the cost of equity usually CAPM (capital asset pricing model) is used do a google search and you should find formulas there are several different ways you can compute this. I don't think Graham used CAPM thought so the model you are looking at might just be estimating the cost of equity.
You are also right that you will most likely have more luck with answers in non trading focused forums. Although many people here could give you the answers many will also not agree with the models and would rather point out its flaws.

Good luck.

5. ### jjk2

thanks thanks. it was very helpful. im just surprised why they didn't bother with WACC....they just like pulled numbers of 8 or 10%,,, cuz 12% is the long term return of equity....according to the book.

6. ### bostonsoxfan

Most models that I've done or looked at have a WACC between 8 and 10% but that was before the credit crunch. The banks won't lend so the estimates are far out estimates. Consider BA, they just stopped giving guidance.

By the way,

Return on Equity is Net Income/Shareholder's Equity and I would consider 12% pretty good.

7. ### AAA30

That is the accounting calculation and is not to be used for valuation.

8. ### jjk2

so for security analysis, say for kraft foods (relatively less risky company), would 6% to 8% be adequate ? this is still boiling my mind, because EPV fluctuates a great deal depending on the Cost of capital number that is used....should i be conservative and just use 10% ?

9. ### AAA30

For Kraft take a look at their bonds
http://reports.finance.yahoo.com/z1?is=Kraft
so cost of debt is about 6-7% at the market.
Cost of equity; Yahoo says a beta of .6 use the ten year for risk free 3.7% market premium of 7% and you get 3.7%+.6*(7%-3.7)=5.68%

Mcap= 41.16B Debt=20B tax rate =30.8%
D/(D + E) Ã 1/(1 - t) ÃRd + E/(D + E) Ã Re = WACC
((20/(20+41.16))*(1/(0.692))*0.07)+(41.16/(20+41.16)*0.0568) =
7.1305% WACC

I used 7% for the market premium and rounded up to 7% for the bonds also rounded up long term debt. Using CAPM for the Equity premium the way I did it is not the best way but makes it easy to understand.
Play with the numbers to see what you come up with a change of 1% can have a big difference in the valuation. So the short answer is 6-8% range looks accurate.

One word of warning though this only gives you a starting point to work with you need to study the finacials and the notes to them and make note of items that may effect the future returns of Kraft like the recent rise in debt levels. This will give you somewhat of a starting point but this disscussion should move over to Elitefinanceprofessor.com now.

10. ### bostonsoxfan

Thanks for the correction. I misread his note return of equity vs: return on equity. I thought he was using it as a screen for valuation.

#10     Nov 6, 2008
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