Present Value of Growth Opportunities

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Present Value Of Growth Opportunities

It is a valuation model in which net present value of a firm’s future investments is explicitly examined. It is calculated by finding the difference between price of equity with constant growth and price of equity with no growth. Formula: PVGO = P(Growth) - P(No growth) = [D1/(r-g)] - E/r where D1 = Dividend for next period r = Cost of Capital or the capitalization rate of the company E = Earning on equity g = The growth rate of the company.

4. The present value of growth opportunities. If a company does not reinvest its earnings and pays out each period's income to the shareholders, its growth rate will be zero, provided that return on equity is constant. Income in each period equals the product of ROE and the company's equity balance. When both of these two components are constant, dividends are essentially a perpetuity, with each period's dividend equal to the company's earnings. Consequently, the value of a company that distributes all its earnings can be calculated as: V = E/r Positive NPV projects earn more than other projects with similar risk. For that reason, companies that reinvest a part of earnings in positive-NPV projects should have a premium to the no-growth base value. Such premium is called the present value of growth opportunities (PVGO). Consequently, the total value of a company that reinvests its earnings equals the base no-growth value plus the PVGO: V = E/r + PVGO If the projects available to the company have negative NPV, retention of earnings would be detrimental to the company's value, as PVGO would be negative. Assuming that the markets are efficient (price of a company equals its value), we can always calculate the PVGO as PVGO = P - E/r Dividing this value by P, the company's price, we can estimate what part of a company's

value depends on its expected growth opportunities. Example An analyst has gathered the following data to analyze a stock.
      

Current stock price: $20. Expected price at the end of the next period: $22. Current period earnings: $2. Expected next period's earnings: $2.2. Stable earnings growth rate to infinity: 6%. Beta: 1.2. Required rate of return: 12%.

The present value of the growth opportunities of this stock is 20 - 2/0.12 = 3.33. Poster danlan2 PVGO=FF*G*E weiw User Comments

when calculating the PVGO in example, we should use the next period earnings instead of current period earnings in numerator, rihgt?

Basic Questions
1 ABC Corp. shares are currently trading at $54.16. If its current earnings are $3.45 and the required rate of return for the stock is 8.9%, which of the following best estimate the stock's present value of growth opportunities (PVGO)? A. $15.40. B. $19.75. C. $22.47. Check AnalystNotes for the correct answer and a detailed explanation.

Review Questions
1 A high proportion of the value of a growth stock comes from: I. Past dividend payments II. Past earnings III. PVGO (Present Value of the Growth Opportunities)

A. III only. B. I and III. C. II and III. Check AnalystNotes for the correct answer and a detailed explanation. Poster cahiz84 any explanation? Past earnings and dividends will be small compared to future potential so they are unlikely to contribute much to the valuation. mordja The present value of future growth opportunities is the only option that makes sense Lamkerst flpe1047 PVGO is calculated by finding the difference between price of equity with constant growth and price of equity with no growth. Past dividends and earnings growth are significant for growth companies. Growth stocks are characterized by the upside of buying an undervalued stock. User Comments

2 The market price of SNI shares is $64. Its 2004 earnings per share were $12.5 and 2005 earnings per share are expected to be $14. The required rate of return is 10%. The present value of growth opportunities of this company is A. -64. B. -61. C. 61. Check AnalystNotes for the correct answer and a detailed explanation. Poster User Comments I don't understand when to use current earnings and when to use expected earnings??? current earnings. The future expected earnings contain the component of growth opportunity and should be included in PVGO

brandsat use current year's earnings, not expected earnings. mishis malawyer

Present value of growth opportunities (PVGO)
Explain how the value of the stock paying dividend is estimated. What is the difference between constant growth dividend and non-constant growth dividend models? What is meant by present value of growth opportunities (PVGO)? The current dividend is $2.00 and is expected to grow 5% indefinitely. What is the value of the company's stock?

Solution Summary

This provides the steps to calculate the Present value of growth opportunities

Wednesday, January 6, 2010

the Present Value of Growth Opportunities, Earnings Retention Rate, and Dividend Payout Ratio
http://thismatter.com/money/stocks/valuation/present-value-of-growthopportunities.htm Whether a company pays out its earnings as dividends or retains its earnings to reinvest in its business depends on its return on equity (ROE) and on investors’ required rate of return, which is dependent on the perceived riskiness of the company’s stock. If a company’s ROE is greater than the market’s required rate of return, or capitalization rate (k), then it would benefit the company’s stock price if the company reinvested its earnings in more growth and distribute little or no earnings as dividends. If its investment opportunities are limited, and its return on investment is than the capitalization rate, then it would pay the company to distribute its earnings as dividends rather than reinvest it. Company Growth Rates Depend on its ROE and Earnings Retention Rate The growth of dividends and the stock price is dependent on company growth, which, in itself, is difficult to project even to the next year, since analysts frequently get it wrong. However, 2 factors obviously related to the company’s growth rate are its return on equity (ROE) and the company’s earnings retention rate (aka plowback ratio), which is the amount of earnings that the company reinvests in its business rather than distributing it to shareholders as a dividend. Since the retention rate and the dividend payout ratio, which is the fraction of company earnings paid out as dividends, equals 1, it follows that: Earnings Retention Rate = 1 – Dividend Payout Ratio Hence, if a company distributes 60% of its earnings as dividends, then its retention rate is 40%. How much a company grows based on the reinvested earnings is commensurate with its ROE multiplied by the retention rate:

Company Growth Rate = ROE x Retention Rate So if the company’s retention rate is 40% and its return on stockholders’ equity is projected to be 50%, then its growth for the coming year should be 20%. Present Value of Growth Opportunities (PVGO) For investors, company growth is desirable only if it increases their return on investment—either its stock price and/or its dividends increase. According to the dividend discount model, it is possible for a company to grow while its stock price declines. A company’s stock price will increase only if the company can reinvest the money and earn a higher rate of return than the required rate of return demanded by investors. The additional growth of a company’s earnings has net present value of growth opportunities (PVGO). PVGO = ROE – Required Rate of Return If its ROE is greater than the required rate of return, then its PVGO is greater than zero, and the stock price will increase if the company reinvests some of its earnings for further growth. If the PVGO is zero, meaning that the ROE equals the capitalization rate, then it makes no difference to the stock price if earnings are reinvested or not; however, an earnings retention rate greater than that necessary to maintain liquidity will lower the dividend without increasing the stock price. If PVGO is negative, then the company will still grow, but its overall ROE will decline, and with it, its stock price. Therefore, the company should distribute most of its earnings as dividends, since that will yield the greatest return for stockholders. We can evaluate each scenario by calculating the intrinsic value of the stock using the dividend discount model, but different return on equity rates and different plowback ratios. The company growth rate, g, is determined by its ROE and by the earnings retention rate (RR): g = ROE x RR Consider a stock that pays a $4 annual dividend, and the required rate of return demanded by investors is 12%. If the company was paying all of its earnings as dividends, then the company is not experiencing growth, so its stock price is determined solely by its dividend and its capitalization rate (k). The constantgrowth dividend discount model calculates the current price of the stock: Stock Price According to Constant-Growth Dividend Discount Model P = D1

───── k – g D1 = Next Year’s Dividend Amount (A complete tutorial on the dividend discount model) For a no-growth company, g = 0, and the above equation reduces to: P = D1/k = $4/0.12 = $33.33 Now suppose that the company earns 20% on its reinvested earnings and it reduces it dividend to $2 per share, and reinvests the other $2, for an earnings retention rate of 50%: g = ROE x RR = 0.20 x 0.50 = 0.10 = 10% Since the company’s ROE is higher than its capitalization rate of 12%, the additional growth has a net present value for stockholders, so the stock price should rise: P = D1/k – g = $2/0.12-0.10 = $2/0.02 = $100.00 As you can see, the stock price is much higher even though the dividend was cut in half. Remember, this is a hypothetical scenario. In the real world, companies usually have an earnings retention rate of 100% in their early, fast-growing phase; then as they grow larger they start paying out a dividend. The dividend payout ratio increases as the company's size increases and its growth prospects decreases. In the real world, stock prices usually decline substantially after a dividend cut, but this is only because it usually indicates that the company is having financial trouble, and if it is, then its required rate of return increases to compensate investors for the increased risk, in addition to other factors causing a stock price decline. Returning to our hypothetical scenarios, now suppose the company’s ROE is only equal to its capitalization rate of 12%, then a 50% retention rate would give the company a 6% growth: P = $2/0.06 = $33.33 Note that this price is equal to the no-growth price, because the company’s return on equity is equal to its capitalization rate; but note also that the dividend is only half what it was in the scenario where the dividend payout ratio was 100%. Hence, with a ROE equal to its capitalization rate, the company can maximize the benefit to its shareholders by distributing all of its earnings as dividends. (Note: companies usually retain some earnings to maintain liquidity.)

For the final scenario, suppose the company’s return on equity is only 10%, then, with a 50% retention rate, its growth rate is 10% x 50% = 5%, which means the stock price is: P = $2/(0.12 - 0.05) = $2/0.07 = $28.57 As you can see, the company grew, but the stock price declined! Note that the price declined even though the dividend was cut in half from the 1st scenario above! Hence, in this scenario, with a negative net present value, both the stock price and the dividend are lower. But if the company decides to pay out all of its earnings as dividends, then it earnings retention rate is 0% and its dividend payout ratio is 100%, and the stock price increases: P = $4/0.12 = $33.33 Hence, a company in this position—sometimes referred to as a cash cow, because such a company is best milked for its dividends—will maximize its return to investors by paying out all of its earnings as dividends. In fact, if a cash cow doesn’t pay out all or most of its earnings as dividends, then it could become a takeover target—major investors will buy it out at the lower stock price for management control, then increase the dividend payout ratio to 100%, which would increase its stock price to its highest intrinsic value, then sell the stock for a profit. Based on the preceding discussion, it can be seen that the stock price can be equated to the no-growth value per share plus the present value of growth opportunities: Stock Price = No-Grow Value per Share + Present Value of Growth Opportunities With this formula, it is easier to see that when the PVGO is positive, it increases the stock price, when it is 0, it makes no contribution to the stock price, but will lower the dividend if any of it is reinvested, and when it is negative, as it is when the company’s ROE is less than the required rate of return demanded by investors, then the stock price declines, even with reinvested earnings. ****************************************************************** ************ The Dividend Discount Model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.[1] In other words, it is used to evaluate stocks based on the net present value of the future dividends. [2]

Dividend discount model is a tool that produces a number based on the data provided. The equation can be written as

where P0 is the current stock price, D1 is the expected dividend, r is the required rate of return, and g is the expected growth rate in perpetuity. This equation is also used to estimate cost of capital by solving for r COST OF CAPITAL :The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. at5:11 AM

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