2.8. The model of growth. PVGO
Principles of Corporate Finance – A Tale of Value
The study of Corporate Finance seems to be a very generic part of business education. Still, it either falls in the trap of intimidating formulas or is superficially journalistic. Both extremes preclude the understanding of the core finance ideas, concepts, and models.
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The learners will gain insight into the essence of corporate finance. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses.
The second part of Week 2 deals with the core concepts in valuing equity. We introduce the idea of the common stock value as a function of its cash disbursements. Then we present some formulas that are used to value common stock on the basis of NPV. We focus on growth as a major contributor to the stock value. We analyze growth drivers and the mechanism of growth. On an example we reveal the influence of investments on the stock value. Finally, we pose some questions with respect to NPV approach.
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Present Value of Growth Opportunities (PVGO)
Valuing growth independently
What is PVGO?
Present Value of Growth Opportunities (PVGO) is a concept that gives analysts a different approach to equity valuation Valuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance. Considering that valuation in stock markets is a combination of fundamentals and expectations, we can break down the value of a stock to the sum of (1) its value assuming no earnings reinvested and (2) the present value of growth opportunities.
We can write it down in the following form:
Value of stock = value no growth + present value of GO
Or we can restate as:
PVGO = Value of stock – value no growth
PVGO = Value of stock – (earnings / cost of equity)
This approach uses the assumption that companies should distribute earnings among shareholders if no better use for it can be found, such as investing in positive Net Present Value (NPV) NPV FormulaA guide to the NPV formula in Excel when performing financial analysis. It’s important to understand exactly how the NPV formula works in Excel and the math behind it. NPV = F / [ (1 + r)^n ] where, PV = Present Value, F = Future payment (cash flow), r = Discount rate, n = the number of periods in the future projects.
We can call the scenario in which a company has no positive NPV projects as a no-growth scenario, and formulate the following:
Value no growth = div / (required return on equity – growth)
where dividends represent 100% of earnings, making div = earnings for this assumption, and growth = 0.
Therefore, we can rewrite the formula as:
Value no growth = earnings / required return on equity
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Example calculations of PVGO
Think of a company with a required return of 12.5%, $57.14 market price and expected earnings of $5 per share.
So, $57.1 = $5 / 12.5% + PVGO
or PVGO = $57.14 – ($5 / 12.5%)
Therefore, can say that $17.14 of the total $57.14 (30%) comes from expectations on opportunities or options available to the company to grow, invest, or even its flexibility to adapt (modify, abandon, adjust scale) investments to new circumstances. We can more easily see these differences in the following table:
We can more easily see these differences in the following table:
Here, we can clearly see that 43.8% of the price observed can be attributed to expectations for Google to grow, enter into new projects and to even keep determining the pace at which other industries move, while McDonalds’ value seems to be perceived as more established and in a difficult position to grow, as the industry becomes saturated and competitors enter the market, along with negative sentiment towards fast food chains.
The value of this analysis comes in many forms. First, it can serve as confirmation of the stage where a company is and to differentiate mature from growing companies. Additionally, it can help the analyst understand if the current price of a stock is justified, i.e., for a company in a highly saturated market and reduced growth opportunities.
This has been a guide to Present Value of Growth Opportunities (PVGO) as an alternative way of thinking about stock valuations. CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification FMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy. designed to transform anyone into a world-class financial analyst.
To keep learning and advancing your career in corporate finance we recommend these additional free resources to help you along your path:
- Economic Value Added Economic Value Added (EVA)Economic Value Added (EVA) shows that real value creation occurs when projects earn rates of return above their cost of capital and this increases value for shareholders. The Residual Income technique that serves as an indicator of the profitability on the premise that real profitability occurs when wealth is
- Valuation methods Valuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance
- DCF formula Discounted Cash Flow DCF FormulaThe discounted cash flow DCF formula is the sum of the cash flow in each period divided by one plus the discount rate raised to the power of the period #. This article breaks down the DCF formula into simple terms with examples and a video of the calculation. The formula is used to determine the value of a business
- WACC formula WACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. The WACC formula is = (E/V x Re) + ((D/V x Rd) x (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator
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