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Growth Opportunity

30 April, 2015 - 10:35

When valuing a company's stock, there is an important distinction which must be made between that and an ordinary perpetuity. A company has the capacity to grow, which must be reflected in the current price.

If a stock price were to valued using a standard annuity formula, it would look something like this:

P_0 = \frac{D_1}{r} (*edit* it should be P_0 = \frac{D_1}{r-g})

Where P0, is the price at time 0, D1 is the dividend at time 1, and r is the required rate of return. However, this clearly does not reflect the level at which a company is expected to grow. This is especially pertinent to start up companies, who may not pay any dividends for a long time, but are expected to become highly profitable in the future. A formula which takes this into consideration is as follows:

P_0 = \frac{D_1}{r} + PVGO (*edit* it should be P_0 = \frac{EPS_1}{r} + PVGO)

g = plowback * ROE