Last Updated on May 30, 2024 at 12:26 pm
In this guest post, R. Srivatsan discusses the pros and cons of using a stock valuation technique known as Earnings Power Box, introduced by Hewitt Heiserman, Jr, in his book, “It’s Earnings That Count: Finding Stocks with Earnings Power for Long-Term Profits”. Regular readers maybe aware that Srivatsan has already introduced the technique in his first post: It’s Earnings That Count: Forget the next Infy; Can you identify the next Satyam?. Since then he has come up with ways to automate the Earnings Power Box calculation using morningstar financials and then with screener.in financials.
This tool is now part of the freefincal investor circle.
Earnings Power Box
This is a plot of two the Defensive EPS (earnings per share) vs Enterprising EPS
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
The idea is to spot where a company falls in.
This is based on: Earnings Power Valuation ModelOpens in a new window (doc file).
If this is new to you, before reading about the pros and cons, I strongly suggest that you head to the fantastic slideshow prepared by Srivatsan and then come back here.
Earnings power box – the nitty gritty stuff
Here are my 5 take-aways on reading Hewitt Heiserman’s book. All my points are with reference to the figure below:
I This tool is NOT for identifying the next multi-bagger. This is a great tool for identifying what I call the MULTI-BEGGARS.
- I am an ignoramus when it comes to direct stock investing (among several other things). I am worried about making too many blunders. Given my personal biases and risk tolerances, this is a great tool for me to know 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 really a judgment call. I will not touch it though
II The concept and framework is 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 a great business. 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, latticework of mentals 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. My preference is to have two eyes although you can comfortably manage with one eye. I definitely 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 few great businesses) and not parrot them mindlessly
- Great stocks can and will be found in ALL 4 quadrants. Can you really stick to your guns of investing only in businesses of Quadrant #1?
- I mean, 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 language to describe that burning feelingJ. Can you sit quietly during this period knowing that the business is a trap while everyone at your office is bragging 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 begins to drift 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 are 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 that count approach is just one way of evaluating a business among millions of approaches / models / frameworks. It is NOT a silver bullet
- This tool will be useful for a subset of investors (for example with limited knowledge level, time, energy, interest and low risk tolerances) and not everyone
- The tool assumes availability ten years’ of reliable and authentic financial statements
- This will be clear when we see some pros and cons of using Morningstar and Screener
| Morningstar | |
| Advantage | Disadvantage |
| Reports Capex exactly like Annual report | Provides only consolidated data |
| Reports FCF directly | No Depreciation, Other income values |
| Reports Balance sheet as % and not as actual values | |
| Missing data for some companies and some years | |
| Screener | |
| Advantage | Disadvantage |
| Reports Other income, Balance sheet values | No Capex, Working capital, FCF data |
| Provides both standalone and consolidated data | Does not follow standard reporting format |
- If you notice carefully, to use Heiserman’s calculation, one needs Capex, Working Capital, Other income, and Balance sheet values. Neither screener nor Morningstar provide ALL the values. One has to do derive the missing quantities or modify our calculations to the available data.
- Of course, you can do all these calculations from the ten annual reports of the company J
- Please note that the following are ignored in the automated tool calculations. The error of omission is assumed to be not so significant to be detrimental to the final conclusions.
- R&D expenses (no data)
- Deferred tax assets and liabilities (confusing calculations and inconsistent reporting)
Gallery (created with MorningStar financials)
Gallery (created with screener.in financials)
This tool is now part of the freefincal investor circle.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)