Present Value of Growth Opportunities (PVGO)
Valuing growth independently
Valuing growth independently
Present Value of Growth Opportunities (PVGO) is a concept that gives analysts a different approach to equity valuation. 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 (i) its value assuming no earnings reinvested and (ii) 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) 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
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. To keep learning and advancing your career in corporate finance we recommend these additional resources: