Basic Earning Power - Your Essential Guide

This article on basic earning power was written by Phillip Richards, a small investor managing his own personal account. He has a Master's degree in Planning and Real Estate and is a deep value investor based in England. He uses Net Net Hunter's high performance net net checklist to identify his stocks. Download our net checklist right now for free. Click Here. Article image (Creative Commons) by Kamil Porembiński, edited by Net Net Hunter.

Basic Earnings Power is just one of a multitude of investment ratios that you have at your disposal as an investor.

But, the earnings power ratio is also one of the most important tools in the investor’s toolbox for evaluating a company’s financial health and a stock’s profit potential. This is just as true for net net investing as it is for any other value approach. 

That’s why it’s frustrating to see so many investors misunderstand the ratio or use earning power value badly while assessing companies.

So, what exactly is earning power? Why is it necessary, and how does it tie into a high-performance strategy such as net net investing? Well, read on to get this key insight.

What is the Basic Earning Power Ratio?

The Basic Earning Power Ratio (BEP) is a measure of the company’s efficiency at producing earnings relative to its assets. The basic earning power ratio formula is simple and takes Earnings Before Interest and Taxes (EBIT) and divides it by Total Assets. 

Basic Earning Power = EBIT/Total Assets

To calculate EBIT, start with net profit and then add back interest and taxes the company paid. Total Assets are simply found on the Balance Sheet.

EBIT = Net Profit + Interest + Taxes

The BEP ratio can demonstrate the business’s ability to generate adequate profits over the long term by reviewing several years to assess the company’s efficiency and earning trends. Simply put, BEP is a quick health check on the company’s profitability. 

However, the ratio does assume that the business will continue to operate in ideal conditions and be able to produce similar earnings into the future. There’s also the question of what to do with this information once you have it. More on this later.

Understanding the Basic Earning Power Ratio

Now you know how to calculate the BEP ratio, what exactly does it mean? 

Well, conventional wisdom suggests that all things being equal, a company with a higher BEP ratio is a more profitable company; it's more efficient at generating income from its assets. The greater the ratio's value, the greater the profitability created from the assets of the company. 

However, a great company with a high BEP ratio and a great investment are two different things. Price paid is the determining factor, and barely profitable companies can be much better buys than very profitable companies. This is the error that most people make. There is another way….

Basic Earning Power Example

XYZ Corp — Income statement

1Net Sales65,299
2Cost of Goods Sold (COGS)32,909
3Gross Profits32,390
4Selling, general and administrative expense18,949
5Operating income13,441
6Interest expense98
7Interest income182
8Other non-operating income, net325
9Earnings from continuing operations before income taxes13,369
10Income taxes on continuing operations3,342
11Net earnings (loss) from discontinued operations557
12Net earnings10,508

Based upon the above formula, EBIT would equate to $13,948 (12 + 10 + 6). Whereas Total Assets (found on the Balance Sheet) = $127,136. Therefore, the BEP ratio for Company XYZ Corp would equal 10.9% ($13,948/$127,136). Is this any good? Potentially, but that would depend on a comparison with the industry and its peers.

Advantages and Disadvantages of Earning Power Ratio

The advantage of using EBIT, and thus BEP, over another metric such as ROA, is it allows for more accurate comparisons of companies. BEP disregards different tax situations and financial leverage while still providing an idea of how successful a company is at using its assets to generate income.

However, like all profitability ratios, BEP does not provide a complete picture of which company is ‘better’ or more attractive to investors. By disregarding debt -- EBIT excludes the interest expense. This could lead to concerns if the company has large amounts of debt (something best avoided). It would also be essential to consider that in an environment where interest rates are rising, the interest expense will again rise.

Another Way…..

 As alluded to earlier, profitability doesn't matter.

Well, not all of the time anyway. Oppenheimer's study conducted on net nets showed little difference in returns between profitable and non-profitable candidates. This is not to say that you should dismiss profitability altogether. But avoid companies that have never turned a profit.

The ideal net net investment candidate is a formerly profitable yet solid company trading at a discount to its NCAV (net current asset value) with a temporary problem that can be resolved. When the problem is solved and profits return, your overall returns should improve significantly. This shouldn't be the only criteria in your stock selection framework, but a simple approach is preferable. 

Take Walter Schloss, for instance, his approach to investing was straightforward — it was finding the stomach to implement that is difficult. Rather than buying cheap, ugly, hated stocks, which Schloss did, many value investors are struggling to implement a quality approach, trying to use an investing style that takes decades of experience to do successfully.

By contrast, the simple investment techniques employed by Walter Schloss and Benjamin Graham -- Warren Buffett's mentor, proved very effective over time. They're also better suited for small private investors because they're simple to employ and based on solid quantifiable metrics.

Net Nets Are The Way

 It may or may not come as a surprise given the website's name, but net nets are the way!

Utilizing the BEP ratio is possible with any investment style, and its application is mostly consistent. With net nets, the industry average BEP gives a clear indication of what earnings could recover. If earnings did recover and profitability returns, it is likely the stock will too. 

Net nets and other deep value companies are beaten down and ugly; there is no getting around it. From a qualitative point of view, it's often hard to find something to like about them. Their significant advantage, however, is their immensely cheap price relative to fair value. 

If you were to put enough of these cheap stocks in your portfolio, the magic of net net starts to happen. Over the long run, net net stocks have returned between 20 to 35% per year. Although Buffett has said, he could return 50% a year with small sums of money.

The Classic Benjamin Graham approach has endured the test of time and is still relevant today, providing investors with market-beating returns over the long term. Net Nets are the way for the small investors to build wealth, just as Buffett once did.

If you want to get started in net net stock investing, you should educate yourself as much as possible before making any investment decision. There is no better place to start than Your Essential Guide to Net Net Stocks

Numerous books on the subject are also available, such as Evan Bleker's book Benjamin Graham's Net-Net Stock Strategy: A practical guide to successful deep value investing in today's markets

You can start putting this strategy in practice today. Click Here to request free net net stock picks and start earning 20%+ annual returns.