earning power

Search for debt-free companies which have displayed stable earning power in the past and are expected to continue to do the same in the future. Average the past earning power, say for the past 5 years (Approaches differ here. You can either use EBIT or Buffett’s Owner’s Earnings (Cash flow from Operations – Capex +/- Changes in Working Capital) Both will result in different results though. Safer to go the Buffet way!) Use a desired interest coverage ratio of 3x-5x (Prof. Sanjay Bakshi recommends 3x for highly stable businesses, 5x for cyclical businesses). I use 5x for all, just to be extremely safe. We can use steps 2 and 3 to find out what is the interest expense that the company can service (EBIT/Interest coverage ratio or Owner’s Earnings/Interest coverage ratio) Divide the interest expense arrived at in Step 4. into the current interest rate to determine debt-capacity of the company; SBI’s AAA bonds were issued recently at 9.5%. Let us be conservative and take an interest rate of 12.5% (a 15% would be even more conservative) Compare this debt-capacity with the current market cap, and if the Market Cap is less than Debt-Capacity, we can consider buying the stock

by Vinayak