Earnings power, asset value and franchise value: reading the Value Ladder

Three layers, from firm ground up

The Value Ladder on a company's Overview plots three ways of valuing the same business on one line, with the price among them. They are ordered by how much each depends on judgment:

• Asset value: roughly what it would cost a competitor to rebuild the business's assets. It needs the balance sheet and no forecast.
• Earnings power: today's normalized after-tax operating profit, valued as if it simply continued. It needs history and a cost of capital, and no growth.
• The DCF range: bear, base and bull forecasts of future cash flow. It needs a view of the future.

The gap between assets and earnings power

When earnings power sits well above asset value, the business earns more than a rebuilt copy of it plausibly would. That difference is called franchise value. Something is stopping competitors from doing the same thing and competing the returns away, and a careful reader asks what that is and how long it lasts.

When the two are close, the business earns roughly what its assets would earn anywhere. That is common and unremarkable, and it means growth adds little value, because new investment earns only its cost.

The gap between earnings power and the forecasts

The distance from earnings power up to a DCF case is the value that case attributes to growth. A price below earnings power pays for none of that growth. A price between earnings power and the bear case pays for some, though less than even the cautious forecast expects. A price above the bull case asks for more growth than any researched case supplies.

The sentence under the ladder states which of these is true for the company in front of you, as arithmetic, never as advice.

When a layer is missing

The framework does not fit every business. Banks are left out entirely, because their borrowing is their product; companies without enough clean history, or without a profit to normalize, show the forecast range alone with a line saying why.