Earnings Power

  

The general goal of for-profit companies is to make money (that's spelled out in the phrase "for-profit"). The extent to which the company can use its business to generate profits is known as its earnings power. The more money a company can potentially make, the higher its earnings power.

Earnings power gets contextualized as well. Like...the potential earnings of a company seeking to "own" the telecommunications industry is massive. The similarly dominant company seeking to "own" the toilet-flushing handle industry...delivers not so massive earnings power.

The phrase gets used with people as well. A neurosurgeon generally has higher earning power than a professional lacrosse player. In fact, we might start a dating service: earningspowerxoxo.com...boil the process down to a single statistic.

Related or Semi-related Video

Finance: What is Discounted Cash Flow?9 Views

00:00

Finance allah shmoop What is discounted Cash flow money air

00:07

gets your money on sale discounted money Yeah kind of

00:11

sort of like that but how can cash be discounted

00:15

and what is flowing anyway Is this like a scene

00:17

from huck finn goes to wall street so the cash

00:20

we're talking about here is cash in the future Got

00:23

it Your company the spice in ator ink sells a

00:30

product that takes any item of food and runs it

00:33

through a processor which makes it pumpkin spice flavor You

00:37

are hated by starbucks everywhere So spice in aitor is

00:40

going to make ten grand by the end of this

00:42

year Fifty grand by the end of next year and

00:45

for five hundred grand by the end of the following

00:48

year and a million bucks by the end of the

00:51

next All right that's not revenues that's profit Or at

00:54

least so you you think it's going to earn a

00:56

million bucks you estimate you guess you hope All right

00:59

Well the value of a company in professional wall street

01:01

he circles is the sum of the parts of its

01:04

future cash flows or cash profits than discounted back for

01:09

risk Meaning it might not actually earn that million dollars

01:11

in four years and time What if those forty years

01:14

or ten years or two years Alright all this means

01:17

that spice in ator ink earning half a million bucks

01:20

in three years is an estimated number It's not certain

01:24

it's hope for begged for prayed for even at least

01:27

in the red states but there is risk It doesn't

01:29

happen Maybe there's thirty percent on that produces three hundred

01:32

grand in profits instead of five hundred grand but ten

01:35

percent odds It produces a million dollars instead of that

01:37

five hundred grand and years out So calculating that risk

01:41

and then discounting it in the value of the company

01:44

Today is a big part of valuing a business parts

01:48

that's the risk side But then there's the time side

01:51

you have to think about as well If you had

01:52

a company you were certain would make half a million

01:55

dollars in profit thirty years from now you know like

01:58

shmoop well that wouldn't be as impressive or valuable as

02:02

a company You were equally certain would make half a

02:05

million dollars in profit next year So that's the time

02:08

component let's add up the notional value of this company

02:12

just as an illustration here Alright Your company's spice in

02:15

ater at the moment has no cash your debt and

02:17

is for illustrative purposes on lee So don't get all

02:20

technical on us and wine about details Try to glean

02:23

a concept here okay So spicy nature will make ten

02:26

thousand Dollars this year in profits it's january now in

02:29

twelve months were eighty percent certain it'll make ten grand

02:31

in profit All right now if we bought the safest

02:34

bond in the world a one year u s treasury

02:37

bond we get three percent interest We fight a discount

02:41

on a thousand bucks Okay that number's serves as kind

02:44

of a bassline whenever we do these kind of analyses

02:47

the u s treasury paper is in generally riskless question

02:51

how much riskier is our company Above and beyond the

02:55

t bill I even company makes that ten thousand dollars

02:58

like could it only make five thousand sure couldn't make

03:01

nothing couldn't lose money Sure couldn't make way more than

03:05

ten grand maybe twenty thirty forty grand Regardless there is

03:08

risk here So the value of that ten thousand dollars

03:11

a year from now carries what is called a risk

03:15

premium tacked onto that three percent figure We're gonna divide

03:19

by it So adding risk premium makes the present value

03:23

less All right let's say that extra risk is pretty

03:26

high like twelve percent That company produces meaningfully less than

03:30

ten grand and profits All right well we discount back

03:32

that One year from now figure of ten thousand dollars

03:36

to be less right Well here's the math you take

03:39

the amount expected to be earned Yes that is the

03:42

cash flow ding ding ding and you divide by one

03:45

plus the quantity of the risk free rate that t

03:47

bill three percent thing plus the risk premium which we've

03:51

guest is in twelve percent So what is the risk

03:54

adjusted and discounted cash flow of ten thousand dollars expected

03:58

or estimated a year from now worth today Well it's

04:00

ten grand divided by the quantity one plus point zero

04:03

three plus point one teo or divided by one point

04:07

one five to the first power for this one year

04:09

away and it looks like that which equals a bit

04:12

under eighty seven hundred bucks So wow Interesting It means

04:16

that the risk of getting that ten grand a year

04:19

from now is high In fact it is worth roughly

04:22

thirteen hundred bucks less today Because of that risk or

04:26

set another way our analysis would suggest that you'd be

04:29

risk neutral if you took a cashier's cheque today for

04:32

eighty seven hundred bucks versus waiting a year and getting

04:36

that Ten grand pay then But if you did wait

04:38

well you'd have a very nice fifteen percent ish return

04:41

on your invested money All right Welcome to risk people

04:44

This is investing Wanna one's order and no extra charge

04:48

from the kindly loving people it's mum inside All right

04:51

And as you'd guess you can get to the total

04:53

value of the company by adding up and then discounting

04:57

future years cash flows of this company in the same

05:01

way when we have the ten grand number already What

05:04

about the fifty k two years from now Well since

05:07

we are comp pounding investment returns we make a call

05:11

too Exponents land with e ticket there all day passed

05:15

And to discount the odds of that fifty k coming

05:17

to us two years from now we apply a similar

05:20

calculation on lee Now we think that the odds of

05:22

fifty k in two years are even riskier than they

05:25

were before Will attach a seventeen percent risk premium toe

05:29

actually getting out fifty grand a profit out of our

05:31

product And we have to discount it back on top

05:34

of the safe or risk free rate of three percent

05:38

Well how's that work well we have fifty thousand bucks

05:41

coming to us We think and hope and pray two

05:44

years from now We then divided by one plus point

05:48

zero three plus the risk premium of point one seven

05:52

squared or to the second power Why Because it's two

05:56

years of compounding away not one Remember I kind of

05:58

mumbled that one year to the first power thing was

06:01

clever on Alright that's Fifty grand over the quantity One

06:05

point two square or fifty grand over one point four

06:08

four or carrying a present discounted value of fifty k

06:12

divided by that one point four four which is a

06:14

little under thirty five grand Well if we carry this

06:17

forward a year and there's even more risk for the

06:19

fur five hundred thousand bucks we expect in three years

06:23

Well then we get something like a risk premium of

06:25

say twenty two percent tacked onto the safe rate of

06:28

three percent or twenty five percent total And we discounted

06:32

back three years or cubed if it looks like this

06:36

Five hundred thousand dollars divided by the quantity one plus

06:39

point oh three plus point two two to the third

06:43

power Or that's five hundred thousand dollars over one point

06:47

two five cubes Which is almost to telling us that

06:51

the present value of that highly suspect five hundred k

06:55

in profits supposedly coming in from spice in ator was

06:59

about five hundred thousand over too or just over two

07:03

hundred fifty grand in present value today Got it Well

07:07

same holds true for that million dollar year and calculate

07:10

the discounted cash value of that million bucks four years

07:14

from now you follow the same pattern and add in

07:16

the million bucks divided by the quantity one Plus you

07:19

know all the other crap in there Yeah So if

07:22

we're getting the total discounted cash flow valuation of the

07:25

company we just add everything up including a sale of

07:28

the company at the end Like if we sold it

07:31

for two and million dollars six years from now we

07:33

discount that back with some you know premiums and someone

07:36

loaded in so that ten million's not a sure thing

07:39

at all We have to assume our guests or dark

07:41

board with blindfolds on the value of the company overall

07:44

will hold for five years from now And yeah that's

07:48

How This kind of cash flow works at least the

07:50

one point overs you're learning here So just be careful

07:52

when you throw that dart You don't want to force

07:54

your business partners to rock and ipad shit no matter 00:07:57.755 --> [endTime] how much that looked cool Oh

Up Next

Finance: What are normalized earnings?
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Normalized earnings are, more or less, the average of what you typically earn. Picture a bell curve. Zoom in on the middle of it. There you go.

Find other enlightening terms in Shmoop Finance Genius Bar(f)