Link between Present Value of Growth Opportunities (PVGO) and Dividend Valuation
Valuing a corporation is a complex exercise. This is partly because there are multiple ways of looking at the same information. One such example is mentioned in this article. Dividend discount valuation and present value of growth opportunities may seem to be two completely different topics. However, there exists a link between them. In fact if the dividend discount valuation is known, we can point out with some degree of precision what is the amount of money that the acquirer is paying anticipating growth opportunities in the target firm.
A Different Perspective:
Lets say that we have used the dividend discount model and come to the conclusion that a certain company is worth $100. We done this by adding the present value derived from the horizon periods to the terminal value which could have been derived using the Gordon growth model.
Now, a different way to look at this would be to consider the value of the company in two parts again. One part would be the value that the firm would have if it simply continued its current level of operations and paid out all its earnings as dividend i.e. the no growth scenario
The residual part would therefore be the present value of the anticipated gains from growth in the firms business. To put it in the form of a formula:
Now, if we just rearrange the components of the formula, we get
In this case, we already know the value of the firm i.e. $100. So, if we can find the value of the firm without the growth, we can obtain the present value of growth opportunities.
Finding the Value of a Firm with No Growth Assumption
To answer this question, we need to think about how does a firm which is not aiming for any growth functions. Well, it gives out 100% of its earnings as dividend and does not invest anything in growth. Hence, the earnings will be the same every year and there will be no growth.
Usually, earnings and dividends mean two very different things. However, in this case, they mean the exact same thing because the firm is paying 100% of its earnings out as dividends.
Since, we know the present dividend, we can solve for the value of the firm with no growth assumption. Lets say this value is $45
Hence, the present value of growth opportunity being paid by the firm is $100 - $45 i.e. $55
Use of this Analysis:
This analysis is widely used within to industry to double check whether the price being paid for the target firm is rational. For instance, lets say if in this case, the target firm is a market leader with 60% market share. We are paying over two times the amount that the firm is worth considering its current operations and assets.
However, since the firm already has 60% market share, it is highly unlikely that the firm will able to grow twice as big unless the market itself is growing rapidly and the firm is expected to get a large share of that growth.
Thus, we must acquire this firm at $100 only if we are sure that it is worth $55 in terms of future opportunities i.e. the assets or the operations which are not present as of now.
The job of an analyst is to check multiple times using different relationships amongst the financial statements and common sense whether the price being paid is fair.
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- Applications of Equity Valuation
- Assumptions Used In Equity Valuation
- Qualitative Issues While Conducting Equity Valuation
- Intrinsic Value and Mispricing
- Absolute Valuation Models Vs Relative Valuation Models
- Choosing a Valuation Model
- Sum of the Parts Valuation
- Dividend Discount Model: Advantages
- Dividend Discount Model: Disadvantages
- Single Period Dividend Discount Model
- Two Period Dividend Discount Model
- Dividend Discount Generic Model
- Dividend Discount Model: Gordon Growth Rate
- Gordon Growth Model: Pros and Cons
- Valuing Preference Shares Using Dividend Discount Model
- Link between Present Value of Growth Opportunities (PVGO) and Dividend Valuation
- Dividend Discount Valuation: H Model
- Phases of Growth and Valuation Models
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- Implied Dividend Growth Rate
- Sustainable Growth Rate: Concept
- Sustainable Growth Rate and the Du-Pont Analysis (PRAT Model)
- Spreadsheet Modeling: Dividend Discount Model
- Estimating Future Dividends
- Dividend Discount Models: Some Points to Consider
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- Single Stage FCFF Model
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- Variations in Cash Flow Models
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