Stock prices are set by the market, supply and demand. They are generally based on a company's financials (how well its business is doing, how much profit it earns, etc.), but the influence is indirect. Moment to moment, prices gets set by the action of buyers and sellers.
Because of this, stocks sometimes get pumped up by unrealistic hopes, or held down by specious concerns. The prices get out of whack compared to the actual financials the company produces.
“This new web browser may have 0.1% market share now, but someday it will bury Google!” “This new smartphone may only be available in Lithuania now, but once it launches in the U.S., bye-bye iPhone!” And so forth.
Created by investor and Columbia professor Bruce Greenwald, Earnings Power Value attempts to discover the fair value for a stock based on its current earning power. Not the hope of business bloggers or the dreams of a fast-talking company CEO, but what the firm's financial statements say now.
In its most basic form, EPV represents the ratio of a company's earnings to its cost of capital. It answers the question: how efficiently does the company turn invested money into profit?
In practice, the math to calculate EPV can get complicated. The actual formula divides adjusted earnings by the weighted cost of capital, or WACC.
There's a long process of finding an adjusted earnings figure...the core profit a company earns without things like interest, taxes, amortization and one-time charges. It also looks at an average over a long period of time to get rid of the regular fluctuations of the business cycle.
A similar series of mathematical maneuvers turns cost of capital into weighted cost of capital. Once all the arithmetical gymnastics are done, you can use the EPV number to compare the intrinsic value of the stock with the market value.
You can see whether the stock price is low compared to its current earnings power (suggesting 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).
Related or Semi-related Video
Finance: What is a Future Value calculat...7 Views
Finance a la shmoop, what is a future value calculation?
[Meditating]
Yeah all right that was supposed to be a Swami sorry yeah maybe this should be
more like a mirror mirror on the wall street thing who's the futurist value of [Girl talking to the mirror]
them all, yeah maybe not.. All right well hopefully you get the
gist a present value that is where you take a pot of profit supposedly being [Pot of gold at the end of a rainbow]
given to you at some point in the future 'n' years away it carries some risk and [Leprechaun at the other end of the rainbow]
there is a current safe or risk-free guaranteed rate of return that this risk [Coins with risk on going to the Leprechaun]
has to sit upon got it so that present value is some discount to whatever [Present value definition written on a 100 dollar bill]
future values are coming your way, like you have an 8% risk premium that sits on
top of a 3% safe rate of return like a government bond that guarantees you 3% [Government bond certificate]
and if the US government bonds are wiped out well it means that we've been nuked
and while you're just a zombie glowing in the dark so you don't worry about [3 zombies walking towards the screen]
your investment returns at that point. All right so here's an example you're
promised 10 grand in five years and well now you
have to discount it back to its present value as ten grand over that 1+1 0.08 [Calculation is shown]
plus point three, that's 1.11 to the fifth power there in the
denominator which is combined during the math area it's a hair under 6 grand so [Loading symbol then the answer appears]
that's the present value of 10 grand five years from now discounted back for
risk and time all right so future value is the inverse thing I'm
not quite the inverse math but we're getting there [The calculation is crossed out]
Here you're just taking a given compounded number in whatever form and
coming up with its future value like you're buying a bond that pays 5% a
year interest and you want to know how much cash it will have thrown off in the [Money falling from the bond certificate]
next 10 years before its principal then comes due and pays all right well you'll [Lots of money starts falling]
add up the flows of cash and we'll say 100 grand invested that's 5 grand a year
in interest or $2,500 twice a year all right and you nerd lingers in the back [People sat in class]
are asking whom but what about the cash you get sooner rather than later
you could reinvest that make yet more money shouldn't that money go into the [Girl at the back of the class]
future value calculation, well yes that distributed money just gets recompiled
and thrown into the stone soup of future value financial calculations thank you [Guy throws cash into the pan full of soup]
nerd lingers but a key point here in noting what the concept is of a [A bowl of soup with money in it]
future value calculation is that there is risk and there is a risk-free rate
and they kind of get married and sit on top of each other in a g-rated way [Guy sits on a girls knee and she kicks him away]
they're all financial leeches against what the total future value might be so
if we have this calculation of a hundred grand invested you can see we have ten
years of giving five grand a year that's 50 grand in total fee add everything up [Timeline showing the investment]
then you get your hundred grand back at the end and your total cash returns to
you will be yes a hundred fifty thousand dollars but it's worth more than that [The total returns calculation is shown]
because you receive the money along the way and you could invest it and gain
more dough yeah god it's how compounding works, got it? So when in doubt consult [Hand waving over a crystal ball]
the crystal ball or the magic mirror if you've got one. Mirror mirror on the
future value, something like that...
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