Earnings Valuation Formula

**dchamber** Sat Feb 18, 2006 3:15 pm

Earnings Valuation Formula
Today I was looking through books at the bookstore and came across 'What is Value Investing?' by Cunningham.
He gives the formula below to value a business, based on earnings, assuming no growth.
V = E/k
Where:
V is the value
E is the current earnings
k is the current cost of capital

I'm having a little trouble understanding this formula. Assume we have EPS of $10 and the cost of capital is $2. That gives me:
V=10/2
V=5
That seems to be saying the stock is worth $5, seems very very low. This does not make sense. Thats half of one years earnings.

Later the book mentions applying the formula again and the example uses k as a percentage. It is not clear what it is a percentage of.

So, if the cost of capital is 20% and earnings are $10, I have:
V=10/.2
V=50
This seems more reasonable. The value per share would be $50 giving a P/E of 5 which makes sense for a company with no growth.

This really seems to be saying that the earnings yield (E/P) should be equal to the cost of capital.

Again, I don't really understand this. What is the cost of capital percentage? Percentage of EPS, of Share Price, of Book, etc.

**teenvestor2** Sat Feb 18, 2006 6:49 pm

You can find the definition of cost of capital here.

Also in the book Expectations Investing is is explained thouroughly.

-Mike

**dchamber** Sat Feb 18, 2006 10:15 pm

I understand what capital is. I don't understand the formula.
V = E/k
What is k? Is it the cost of capital? Is if a capital as a percentage of something? Of what?

And given that how does it really help you calculate value? What does this value represent.

I do not intuitivly understand this formula.

Have you ever heard of this formula?
The book also states it is discussed in a book by Bruce Greenwald but it does not name the bokk.

**teenvestor2** Sat Feb 18, 2006 11:25 pm

Cost of Capital is just a business cost of doing business. It is sometimes used as a discount rate.

The book is Value Investing: From graham to Buffett and Beyond

Using the formula you showed is basically just doing a terminal value calculation. This is part of a traditional DCF, you're just skipping the growth projections.

-Mike

**dchamber** Mon Feb 20, 2006 12:08 pm

I'm gonna look for that book at the bookstore today. I have a question. Assume the cost of capital is 100% of earnings, and earning are $10.. That would give the following valuation.
V=E/k
V=10/1
V=10

If I earn $10 but must put $10 in capital back in it seems like I would have a value of $0.

I just don't intuitivly understand this formula.

Don

**blast_investor** Mon Feb 20, 2006 6:42 pm

The exact cost of capital can be obtained from Wall Street research firm.

But for most invidual investors, there is no need to research too deep into this issue. A simple rule of thumb is enough to estimate this cost of capital.

A stable business such as grocery stores etc, the cost of capital (K) is 10% to 12% or 0.1 to 0.12

A venture like business, dangerous business such as Tech start up needs cost of capital up to 20%, or 0.20.

Of course, cost of capital also has to do with interest rate level. When interest rate rises due to inflation, the cost of capital rises too.