We have revamped our Automated Stock Analyser with the Earnings Power Box Valuation Model. This was introduced by Hewitt Heiserman, Jr, in his book, “It’s Earnings That Count: Finding Stocks with Earnings Power for Long-Term Profits”.
History: Srivatsan, a regular contributor at freefincal, introduced me to this model and incorporated a simple way to compute it. This was his first post: It’s Earnings That Count: Forget the next Infy; Can you identify the next Satyam? This is a fantastic slide deck. Please be sure to read if you are interested in the tool.
Also, see his article: We spotted a “Multi-beggar” stock three years back – You can, too!
The earnings power box became part of the freefincal stock analysis tool (requires massive updating). Starting now, we shall be revamping the entire tool.
Another reader, Lokesh Verma, then used this to list 50 stocks with solid earnings power: The Ability to self-fund and create value. (Please note this information is now outdated)
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Hewitt Heiserman Jr has used the US version of this analyzer (it does not work anymore) and was impressed with it.
Disclaimer: The data presented below is for informational purposes only and should not be construed as investment advice. Please do your research before investing. Neither Srivatsan nor I will be responsible for your losses or gains. Please take some time to read and understand the pros and cons of the method before proceeding further.
What is Hewitt Heiserman Jr.’s Earnings Power Box?
This plots the Defensive EPS (earnings per share) vs Enterprising EPS. The idea is to spot where a company falls in. This is based on the Earnings Power Valuation Model (doc file).
Srivatsan has defined enterprising and defensive EPS as follows: Enterprising EPS = (Enterprising Income)/(Shares Outstanding) and Defensive EPS = (Defensive Income)/(Shares Outstanding). Therefore:
Enterprising Income = Net Income – (15% x total capital). Here 15% is the weighted average cost of capital (WACC) and is an expected return (users can change this). Also, 15% x total capital = enterprising interest.
Defensive Income = Free Cash Flow – change in working capital since last FY. Now, over to Srivatsan.
The idea is to spot where a company falls in.
Important Note: The updated tool uses Moneycontrol stock financial data. This does not have free cash flow (FCF) as an entry.
FCF = Cash Flow From Operating Activity minus capital expenditure (Capex)
I have used Capex = Change in fixed assets + Depreciation. The FCF computed this way does not match the FCF entry listed in portals like MorningStar, YahooFinance, etc.
I asked Srivatsan if we can use this, and he said, “We can use this – it will under-report the FCF and be conservative. That’s all. The error will be ~20% max. The trend and conclusions will hold if we look at the 10-year data points. This will be approximately right and exactly wrong 🙂 ”
If uncomfortable, you can use the FCF reported in other portals.
How to use the Earnings Power Box?
I) This tool is NOT for identifying the next multi-bagger. This is a great tool for identifying what Srivatsan calls the MULTI-BEGGARS.
He explains the pros and cons of using the tool below.
- I am an ignoramus regarding direct stock investing (among several other things). I am worried about making too many blunders. Given my biases and risk tolerances, this is a great tool for knowing WHERE NOT TO PUMP my hard-earned money.
- Anything in Quadrant #3 is a straight reject
- To merit a second thought, the company has to be the bare minimum in Quadrant #2. Quadrant #4 is a judgment call. I will not touch it, though
II) The concept and framework are amazingly simple yet brilliantly profound.
- Any business that generates free cash flow (FCF) and Returns above the cost of capital (ROIC) year after year is great. That’s it. This is true for a roadside petty shop or a Fortune 500 company.
- Forget about the durability of moats, sustainable competitive advantage, intelligent fanatics, and a latticework of metals and their models. Proof of the pudding is in the eating. All these should result in FCF and superior ROIC; If not, it is a great dog and pony show.
- View these two metrics as two eyes of any business. I prefer two eyes, although you can comfortably manage with one eye. I do not want to go blind.
III) Complete Disconnect from market behaviour/psychology – a boon or bane?
- Use this tool IF and ONLY IF
- You are a brutally rational and unemotional investor
- You like to take few concentrated bets with huge payoffs
- You really would like to follow Buffettisms (of owning a few great businesses) and not parrot them mindlessly
- Great stocks can and will be found in ALL 4 quadrants. Can you stick to your guns and invest only in businesses in Quadrant #1?
- You should be like Boman Irani’s hand in Munna Bhai MBBS. Now, can you do it? Even Boman Irani says his hand will shake while operating on his daughter.
- Over the last two years, I have seen stocks in Quadrant 3 zoom 2x, 3x, 5x or even more, and there are no words in English to describe that burning feeling. Can you sit quietly during this period, knowing that the business is a trap while everyone at your office brags during coffee breaks?
IV) Makes entry/exit decisions a lot easier.
- When to buy – When the company first enters Quadrant #1. This makes sense because it means that for the first time, the business has started to be self-sufficient and grow and hence can be expected to start compounding returns
- When to sell – When the company is no longer in Quadrant #1 and drifts to other quadrants. Again, this makes sense because, for whatever reason, business is facing headwinds and is no longer able to sustain the cash flows or returns (or both)
V) Makes Annual stock portfolio review a lot easier
You can use this tool to:
- Assess where the stocks in your portfolio currently stand in the earnings power box.
- How their business performance is trending year after year
- Buy more or liquidate positions accordingly
CAVEATS on the Concept and the Automated Analyzer (Morningstar and Screener versions)
- Heiserman’s Earnings is just one way to evaluate a business from millions of approaches/models/frameworks. It is NOT a silver bullet.
- This tool will be useful for a subset of investors (with limited knowledge level, time, energy, interest, and low-risk tolerances) but not everyone.
- The tool assumes the availability of ten years of reliable and authentic financial statements.
- If you notice carefully, one needs Capex, Working Capital, Other income, and Balance sheet values to use Heiserman’s calculation. Whatever is not directly available must be derived, which comes with limitations.
- Please note that the following are ignored in the automated tool calculations. The error of omission is assumed to be less significant than detrimental to the conclusions.
- R&D expenses (no data)
- Deferred tax assets and liabilities (confusing calculations and inconsistent reporting)
- It is unsuitable for Banking stocks since they have a lot of leverage.
Screenshots of the Earnings Power Box Stock Analyzer
There is only one input – the stock code used by Moneycontrol. Stock codes of Nifty 500 stocks are included. You can search for the code and enter it in the green cell. Please wait about a minute for the information to populate.
This is the financial data retrieved from MoneyControl.
This is the result for Dabur.
How to access the Earnings Power Box Stock Analyzer
The Earning Power Box Stock Analysis Module is a Google Sheets file and is part of the freefincal investor circle. This is an exclusive space for investors, advisors, fintech employees, and students to access financial planning and insurance tools, mutual fund analysis tools, coding strategies, and Excel macros for data extraction.
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