What it means
Reported profit for any single year is a noisy number. It contains restructuring charges, asset sales, legal settlements, unusually mild weather and one-off contracts that will not repeat.
Earnings power is what remains once those distortions are removed and the business simply runs as it is. The concept matters most in valuation and lending.
A bank sizing a loan wants to know the profit that will still be there in a poor year, not the profit in the best year on record. An acquirer paying a multiple of earnings needs that multiple applied to a sustainable figure, otherwise it pays a full price for profit that evaporates twelve months later.
Estimating it usually means averaging margins across a full business cycle rather than taking one year in isolation. A common approach applies the average operating margin of the last five to seven years to current revenue, which gives a normalised operating profit.
Tax is then deducted to reach an after-tax figure that can be capitalised into a value. Value investors formalise this as earnings power value, which capitalises normalised after-tax operating profit at the cost of capital and deliberately assumes zero growth.
Anything the market pays above that number is, by definition, payment for growth that has not yet happened. The gap between the two is a useful discipline when a story is running ahead of the numbers.
The main nuance is judgement about what genuinely counts as recurring. Restructuring charges that appear in every single year are not really one-off, and stripping them out flatters the picture considerably.
The test is whether a cost sits outside normal operations, not whether management has chosen to label it as exceptional.
In practice
Real-world examples.
Example
A steel distributor earned $18,000,000 at the top of the last cycle and $2,000,000 at the bottom. The board uses a mid-cycle earnings power figure of about $8,000,000 when setting the dividend, so that the payout survives the next downturn instead of being cut halfway through it.
Example
A restaurant group reports net profit of $6,200,000, including a $1,200,000 insurance settlement following a kitchen fire. A buyer assessing earnings power works from $5,000,000, because the settlement is not part of what the restaurants can produce next year.
Example
A lender assessing a haulage business finds three years of profit ranging from $900,000 to $1,600,000, with the highest year boosted by a short-term contract that has ended. It sizes the facility against an earnings power estimate of $1,100,000 and sets covenants accordingly.
Formula
Calculation
Normalised operating profit = revenue x average operating margin across the cycle. Earnings power value = normalised operating profit x (1 - tax rate) / cost of capital.
A packaging business has revenue of $100,000,000 and an operating margin that has averaged 12% over the last seven years, so normalised operating profit is $100,000,000 x 0.12 = $12,000,000. At a 25% tax rate the after-tax figure is $12,000,000 x 0.75 = $9,000,000. Capitalising that at a 9% cost of capital gives an earnings power value of $9,000,000 / 0.09 = $100,000,000 for the whole enterprise. Subtracting net debt of $20,000,000 leaves $80,000,000 of equity value, and across 8,000,000 shares that is $10.00 a share. If the shares trade at $13.50, roughly 26% of the price is being paid for growth the existing operations do not yet deliver.Case study
Seen in the real world.
The following is an illustrative, fictional scenario. Kestrel Packaging is an invented corrugated box manufacturer that had a spectacular year when a competitor's plant closed, taking operating margin from its usual 11% to 19% on revenue of $80,000,000.
Management proposed valuing the business off that single year for a planned management buyout. The independent adviser instead calculated earnings power using the seven-year average margin of 12% on current revenue, which produced normalised operating profit of $9,600,000 rather than the $15,200,000 the peak year suggested, a difference of $5,600,000 before any multiple was applied.
Within eighteen months the competitor's plant reopened under new ownership and Kestrel's margin returned to 11%. In this fictional illustration the earnings power approach protected both the buyers and the lender from a valuation built on a temporary windfall.
Watch out
Common mistakes.
- Using the most recent year's profit as earnings power when that year sat at the top or the bottom of a cycle.
- Accepting every item management labels as exceptional, including charges that reappear in the accounts year after year.
- Confusing earnings power with a forecast, when it deliberately assumes the business stays exactly as it is rather than growing.
Questions
People also ask.
How is earnings power different from normalised earnings?
They overlap heavily, but normalised earnings usually refers to the adjusted profit figure itself while earnings power extends that figure into a statement about sustainable capacity, often capitalised into a value.
Does earnings power include growth?
No, and that is the point of it, because keeping growth out gives a floor value that can be compared with the market price to see how much optimism is embedded.
What cost of capital should be used to capitalise it?
Typically the weighted average cost of capital for the business, which reflects the blended cost of its debt and equity funding and the risk of its industry.
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