Present value of Growth Opportunities (PVGO) is a concept that gives analysts a different approach to equity valuation. Considering that valuation in stock market is a combination of fundamentals and expectations, we can break down the value of a stock as 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:
Or we can restate as:
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 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:
where dividends represent 100% of earnings, making div = earnings for this assumption, and growth = 0.
Therefore, we can rewrite the formula as:
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/.125)
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 spot more easily these differences in the following table:
Here we can see clearly that 43.8% of the price observed, can be attributed to expectations for Google to grow, enter into new projects and even to keep determining the pace at which other industries move, while McDonald`s value seems to be perceived as more established and in a difficult position to grow, as the industry saturates and competitors enter the market, together with a combination of negative sentiment towards the fast food chains.
The value of this analysis comes in many forms. First, it can serve as confirmation of the stage at which a company is and to differentiate mature from growing companies, additionally, it can help the analyst to understand if the current price of a stock is justified, for example, for a company in an environment of high saturation of the market and reduced growth opportunities.