Pros & Cons of Finding Stocks with Earnings Power for Long-Term Profits

Published: May 26, 2017 at 9:47 am

Last Updated on

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.

Earnings Power Box

This is a plot of two the Defensive EPS (earnings per share) vs Enterprising EPS

The idea is to spot where a company falls in.

Earnings Power Box

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.

  1. 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
  2. Anything in Quadrant #3 is a straight reject
  3. 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.

  1. 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
  2. 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
  3. 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?

  1. 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
  1. 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?
  2. 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
  3. 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

  1. 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
  2. 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:

  1. Assess where the stocks in your portfolio currently stand in the earnings power box
  2. How their business performance are trending year after year
  3. Buy more or liquidate positions accordingly

CAVEATS on the Concept and the Automated Analyzer (Morningstar and Screener versions)

  1. 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
  2. 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
  3. The tool assumes availability ten years’ of reliable and authentic financial statements
    1. This will be clear when we see some pros and cons of using Morningstar and Screener
Morningstar
AdvantageDisadvantage
Reports Capex exactly like Annual reportProvides only consolidated data
Reports FCF directlyNo Depreciation, Other income values
Reports Balance sheet as % and not as actual values
Missing data for some companies and some years

 

Screener
AdvantageDisadvantage
Reports Other income, Balance sheet valuesNo Capex, Working capital, FCF data
Provides both standalone and consolidated dataDoes not follow standard reporting format

 

  1. 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.
    1. Of course, you can do all these calculations from the ten annual reports of the company J
  2. 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.
    1. R&D expenses (no data)
    2. Deferred tax assets and liabilities (confusing calculations and inconsistent reporting)

Gallery (created with MorningStar financials)

Want to know how to reduce fear, doubt and uncertainty while investing for financial goals? Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community

Gallery (created with screener.in financials)

Download Links

MornngStar Version: 

Download version 14th of the freefincal stock analyzer June 16th, 2019 <== Latest!

Download the freefincal stock analyser V13 with Earnings Power Box May 2017

The automated stock analysis sheet

  • pulls financials from morningstar and analyses them
  • pulls adjusted stock price history from money control, and
  • calculates intrinsic value six different ways!

It also pulls annual (standalone/consolidated) and quarterly financials from Value Research online.

Valuation models available:

1) Price Multiple Model

2) Sustainable Growth Rate

3) Book Value Growth Rate (Buffett’s approach to valuation)

4) Discounted Cash Flow(DCF)

5) Reverse DCF Valuation

6) Graham formula  and Graham number

7) Piotroski Score for the last 9 financial years

8) Earnings Growth Estimate.

9) Automated Return on Equity Analysis with the Dupont Formula

10) Altman Z-score

Screener.in version: Download the May 2017 freefincal stock analyser scr edition

This can perform all the above valuations except 4 and 5.

Do share if you found this useful
Hate ads but would like to support the site? Subscribe to our ad-free newsletter and get beautifully formatted full articles delivered to your inbox!

About the Author

Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

About freefincal & its content policy

Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. We operate in a non-profit manner. All revenue is used only for expenses and for the future growth of the site. Follow us on Google News
Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication.Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only 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

Our Publications


You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingThis book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
  

Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want

Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new

This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when traveling, how traveling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download) 

Free Apps for your Android Phone

Comment Policy

Your thoughts are the driving force behind our work. We welcome criticism and differing opinions.Please do not include hyperlinks or email ids in the comment body. Such comments will be moderated and I reserve the right to delete the entire comment or remove the links before approving them.

1 Comment

  1. Sir, If possible, kindly make a video for your stock screener template having earning power box feature.
    Thank you for your efforts in dissemination of financial literacy.

Leave a Reply

Your email address will not be published. Required fields are marked *