cv4cfa

Imagine a company that earns (E) $1.00 per share and has a cost of equity of 10%. If this compnay can find projects or investment opportunities that'll return in excess of 10% , it's a profitable venture and that "excess" return will measure the present value of growth. If it can't reinvest that dollar at more than 10%, then the compnay is depleting the shareholder value and is better off paying out 100% of its earnings. This latter part is known as no-growth factor.

Let's look at it this way: The current stock price is $20.00, EPS of $1.00, r of 10%. Quantitatively, the equation would be: $20 = $1.00/0.1 + PVGO. This means (after some algebra) that of the $20 value of the stock, $10 comes from its growth opportunities and the ability to earn profits in excess of the "other" $10 contributing to that value.

As bchadwick mentioned, it can also be looked as Franchise PE (made up of a Growth Factor and a Franchise Factor), with FF = 1/r - 1/ROE.

Hope this helps.

EDIT: The answer to your second question is: YES. The higher the PVGO, the more profitable the company is (which could be a result of smart management, competitive advantage, strong brand, etc) the higher IRR it earns on reinvesting its earnings compared to the cost of its equity.



Edited 1 time(s). Last edit at Thursday, May 27, 2010 at 03:21AM by Iginla2010.