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 409a valuation?29 Views
finance a la shmoop. what is a 409a valuation. it has nothing to do with that
cleanser thing. yeah get that out of here all right. [cleaner scrubbed across a counter top]
well after a lab accident you were inspired to start a new company which
produces glow-in-the-dark bunnies .great Christmas gifts until you get bored with
them yeah. then you think well really cool glow-in-the-dark Stew.
you're the founder of globe bunny and you raised two million dollars in
preferred stock from investors. like most startups your shares are common stock so
if the company fails the investors get paid before you do. like if you sell it
for scrap. you need to grant stock options to
employees you're gonna hire. like you know your chief carrot officer or
executive vice president of adorableness. well you need to grant stock options to
those key officers but how do you price them like how do you set the value or
the strike price of those options ? well you own 4 million shares of common stock
and investors own 2 million shares of preferred priced at $1 each. that
preferreds a buck a share .so notionally your stake in the company is worth 4 [equation]
million dollars. but glow bunny barely has even a product. well ok it's a cute
product it's just kind of creepy. but it has no revenues and certainly no profits
so glow bunny is still at a highly vulnerable stage where it's very likely
to go bankrupt. statistically some 98% of these kinds of
startups either go fully bankrupt or pay back less than what investors you know
invested. so the 4 million shares common stock are certainly worth less than the
4 million bucks at this moment right? and it is the common stock which is the type
of stock which employees will get stock options in. that is an employee starting
at the company might get a modest salary and then a hundred thousand stock [equation]
options which convert into shares of common stock at a price. so the question
is what price are what strike price applied to those stock options is used
to set the price at which an employee can buy out those shares of stock? and
this pricing is a big deal because if the CEO just wants to gift to the
employees a super low strike price number
the IRS will view that as a taxable event and then bad things happen to
pretty much everyone. like it's a gift tax in that's taxable right ?well it's
the 409a valuation which determines that strike price and like Goldilocks
porridge you want it just. right if it's too high the employees don't get value
for taking the risk of working for the volatile startup you've started at a low
salary .and if the stock options are too low or priced too low well the IRS comes
a-callin .yeah Goldilocks. alright so the process a 409a valuation is made by
calling a lawyer or a bank who produces these valuation reports regularly .you [man on the phone]
know for a modest fee and yes glow bunny will pay them a modest fee .and in return
the firm will produce a piece of paper stating their rationale as to why via
say 4 million shares of common are really worth just a dime each not a
dollar. but they'll always be in a discount to the price per share of the
preferred stock because preferred always gets paid out ahead of common stock in a
liquidation. and there are multiple analyses the firm will look at. like 1
the price preferred shares were bought out like that dollar. 2 discounted cash
flow analysis of the projected revenues and profits and all that stuff over the
next n years. and or 3 comparable values for companies that are in similar or
ancillary spaces in like what their 409 a's were priced at at the same time. got [analyses of stock pictured]
it so a whole bunch of things go into the soup here or stew. and it's re
different not bunnies stew. now looking at you .alright and if they come up with a
diamond share well then it will be that diamond share that will be the strike
price of the options granted. meaning on the 4 million remaining shares they're
saying they're worth and give or taken four hundred grand. so if an employee who
just received one hundred thousand stock options in glow bunny with a diamond
strike price wanting to buy out their stock options and actually be a full
owner of the common stock as opposed to have options on it well they would need [equation]
to write a check for a hundred thousand times a dime or ten grand to glow bunny.
they would be the proud owner then of those hundred thousand shares of common
stock and because glow bunny and conveniently over stocked this corridor
well your very own truckload of bunnies. yeah there you go have fun cleaning that
up, and believe us when we say that everything about these bunnies
glows. [glowing bunny poops]
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