Present Value of Growth Opportunities (PVGO)
The concept of Present Value of Growth Opportunities (PVGO) can play a role in financial analysis and decision-making.
PVGO provides a means of quantifying the value today of a company’s future growth prospects.
This helps traders/investors determine if a company is undervalued or overvalued based on its future growth potential.
Key Takeaways – PVGO
- The concept of Present Value of Growth Opportunities (PVGO) helps assess the value of a company’s future growth prospects, aiding financial analysis and decision-making.
- PVGO is calculated as the difference between a company’s current share price and its no-growth value per share, indicating the portion of the stock’s value attributed to future growth opportunities.
- PVGO can play a role in determining if a company is undervalued or overvalued based on its future growth potential, which is valuable information for traders, investors, and even company decision-makers.
Understanding PVGO
The Present Value of Growth Opportunities is a component of a company’s share price that is attributed to its future earnings growth.
In essence, it is the difference between a company’s current share price and its no-growth value per share (i.e., the value of the company if it had no future growth opportunities).
You can take a company’s PVGO and divide it by the current share price to determine what percentage of its price is attributed to future growth opportunities.
You can basically think of it as like a decomposition (how much attributed to growth and how much attributed to current earnings).
Calculation of PVGO
The formula for calculating PVGO is as follows:
PVGO = P – (E / r)
Where:
- P is the current price per share
- E is the earnings per share, and
- r is the required rate of return
The E/r portion of the equation represents the value of the company’s existing assets or earnings, while PVGO represents the value of its future growth.
Note that P will sometimes be represented by Vo and the formula may also often appear as:
PVGO = Vo – (E / r)
Importance of PVGO in Investment Analysis
A higher PVGO indicates that a large portion of the stock’s value is based on its future growth potential.
A company with a high PVGO could be considered overvalued, especially if the market’s expectations for growth are not realized.
An analogous concept is “justified P/E” or how much of a company’s P/E is based on current earnings, with the rest split into growth opportunities.
Applications of Gordon Growth Model: Justified P/E and PVGO
PVGO and the Tech Industry
The tech industry provides a great example of high PVGO values.
Many tech companies were trading at high multiples of their earnings, indicating that investors were pricing in substantial future growth.
PVGO and Value Investing
For value investors, a company with a low PVGO might be attractive.
These investors often look for companies whose shares are undervalued based on their current earnings or assets, rather than their future growth prospects.
A lower PVGO suggests that a larger portion of the company’s share price is based on its existing earnings or assets.
PVGO and Growth Investing
On the other hand, growth investors might be more attracted to companies with high PVGOs.
These investors are looking for companies that are expected to grow at an above-average rate compared to other companies.
Growth stocks tend to have a very high PVGO, indicating that a significant portion of its share price was based on future growth expectations.
Challenges in Using PVGO
There are several challenges in using PVGO.
First, it requires making assumptions about a company’s future earnings growth and the appropriate discount rate. These assumptions can be uncertain and subject to change.
Second, PVGO is a relative measure, meaning it must be compared to other companies or the market as a whole to be meaningful.
Example Calculation of PVGO
We have our formula:
PVGO = P – (E / r)
- A company has a current stock price of $50.
- The expected earnings for the company are $6 per share.
- The cost of capital for the company is 20%.
- The present value of zero-growth-earnings is $30 ($6 / 0.20 = $30).
- Therefore, the PVGO for the company is $20 ($50 – $30).
We can then compare the PVGO to the share price to see what percentage of the market price is assigned to future growth opportunities.
$20/$50 = 40%
So, 40% of the market price is based on future growth.
How to Interpret PVGO in Trading and Corporate Decision-Making
PVGO can offer insightful guidance when it comes to interpreting a company’s potential for growth and deciding whether a corporation should reinvest earnings or distribute dividends.
Dividends or Reinvestment?
When assessing PVGO, a higher PVGO indicates that earnings should preferably be reinvested rather than issued as dividends to shareholders, and vice versa.
This is because shareholder wealth is most effectively maximized when companies continuously reinvest earnings into projects that offer positive net present value (NPV).
These are projects that, over time, are expected to generate more wealth than they cost to undertake.
However, in cases where a company has no worthy projects to pursue – projects that provide satisfactory returns – these zero-growth companies are better off distributing their earnings to shareholders as dividends.
This is often the case with mature companies in saturated markets where growth opportunities are limited.
The PVGO metric also provides insights when it comes to interpreting negative and positive values:
Negative PVGO
A negative PVGO suggests that by reinvesting earnings, a company is actually eroding value rather than creating it.
In this case, the company should distribute more of its net earnings to shareholders as dividends.
This situation could be observed in companies operating in declining industries or ones facing significant operational challenges.
Positive PVGO
On the other hand, a positive PVGO – where a company’s Return on Equity (ROE) is greater than its cost of capital – implies that reinvesting earnings can generate more value for shareholders than distributing dividends.
An industry-leading PVGO is an indication that the company has many more growth opportunities ahead of it compared to its peers, which could lead to a potential rise in its future share price.
FAQs – PVGO
What is PVGO?
The Present Value of Growth Opportunities (PVGO) is that it is a valuation measure applied to growth stocks.
It represents the component of the company’s stock value that corresponds to (expected) growth in earnings.
It allows an analyst to assess the extent to which the share price represents the current business, and to what extent it reflects assumptions about the future.
Here are some other key points about PVGO:
- It is calculated as the difference between the stock price and the present value of its zero-growth-earnings.
- The present value of zero-growth-earnings is calculated by dividing the expected earnings by the cost of capital.
- A high PVGO means that a company may have a lot of growth opportunities that it can pursue, which would increase the company’s value in the future.
- A low PVGO means that a company may have fewer growth opportunities, or that the market is not expecting much growth from the company.
How is PVGO calculated?
PVGO is calculated using the formula: PVGO = Vo – E/(r), where Vo represents the market value of the firm’s equity, E represents earnings per share, and r represents the cost of equity (expected return).
This formula essentially subtracts the current earnings of a company from its market value, leaving the value attributed to growth opportunities.
How can PVGO be used to guide decision-making on reinvesting earnings or paying out dividends?
A positive PVGO indicates that a company’s Return on Equity (ROE) is greater than its cost of capital.
This implies that reinvesting earnings into future growth can generate more value for shareholders than dividend payments.
In contrast, a negative PVGO suggests that reinvesting earnings erodes company value, implying it would be more beneficial to distribute earnings as dividends.
What does a negative PVGO mean?
A negative PVGO implies that a company is destroying value by reinvesting earnings back into the business.
In such a situation, the company should ideally distribute more of its net earnings to shareholders as dividends.
What does a positive PVGO signify?
A positive PVGO suggests that a company has opportunities to create more value by reinvesting its earnings back into the business.
This is often the case when the company’s Return on Equity (ROE) exceeds its cost of capital.
What is the relationship between PVGO and the market share price (Vo)?
The PVGO can be expressed as a percentage of the current market share price (Vo).
A high PVGO percentage of Vo suggests a greater present value contribution from future growth expectations.
Conversely, a low PVGO percentage of Vo suggests a lower present value contribution from future growth expectations.
How does PVGO influence trading/investment decisions?
Investors use PVGO to assess the growth potential of a company.
A high PVGO could be attractive to growth-oriented investors, indicating that a large proportion of the firm’s value is derived from future growth opportunities.
Conversely, a low or negative PVGO might attract income-oriented investors, suggesting that the company could potentially distribute more earnings as dividends.
How does industry context impact PVGO?
Different industries can have differing norms for what constitutes a “good” PVGO.
For example, in high-growth technology sectors, a high PVGO is expected due to the nature of rapid growth and reinvestment in these industries.
Conversely, in more mature, slower-growth sectors like utilities, consumer staples, or manufacturing, a lower PVGO might be the norm, reflecting the focus on steady earnings and dividend payouts.
How does PVGO change over a company’s lifecycle?
PVGO tends to be higher during the early stages of a company’s lifecycle when it has more growth potential and fewer existing cash flows to discount.
As the company matures, the PVGO typically decreases as growth opportunities become scarcer and cash flows become more predictable.
Conclusion
The Present Value of Growth Opportunities is a tool for traders, investors, and company decision-makers when evaluating a company’s stock.
It provides insights into how much of a company’s value is based on its future growth prospects.
For company decision-making, if PVGO is less than zero, it’s generally better for the company to distribute earnings as dividends. Conversely, if PVGO is greater than zero, it’s generally advantageous for the company to reinvest earnings.
The PVGO metric can be expressed as a percentage of the current market share price (P).
A high PVGO percentage of P implies a higher present value contribution from future growth expectations, suggesting the market sees significant future growth potential in the company.
On the other hand, a low PVGO percentage of P denotes a lower present value contribution from future growth expectations, indicating that the market is not anticipating substantial future growth.
Therefore, understanding and interpreting PVGO can provide insights into a company’s growth prospects and can aid in decision-making related to reinvestment versus dividend payout strategies.