pvgo thought process for equity valuation

The PVGO Thought Process For Equity ValuationBy Michael O. Ijeh

July 16, 2016

Keynes’s Famous Beauty Contest Quote For The Stock Market

"It is not a case of choosing those [faces] that, to the best of one's judgment, are really the

prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached

the third degree where we devote our intelligences to anticipating what average opinion

expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth

and higher degrees.“

Keynes, General Theory of Employment, Interest and Money, 1936

Keynes’s Belief – Is It True?

Keynes believed that behavior of a beauty pageant judge was happening in the stock market

This would have people pricing shares not based on what they think their fundamental value is, but rather on

what they think everyone else thinks their value is, or what everybody else would predict the average assessment

of value to be.

It could be true, but one can still gain a competitive advantage in the stock market by viewing the

market in a different manner

Based on “Keynesian Beauty Contest” Wikipedia webpage

How To Gain A Competitive Advantage In Stock Selection

Superior Forecast*

Different View of Valuation*

Understanding Investor Sentiment*

Having Insider Information

So is there a way to combine all of these methods for gaining a competitive

advantage in stock selection? (Well, maybe not the insider information)

*Based on FaVeS framework from AnalystSolutions

Challenges With Traditional Valuation Techniques

Market Approach (Multiples)

Can be tough finding a good peer group of

comparable companies since no two companies are

the same

Market valuations can fluctuate dramatically

Market prices aren’t always based on fundamentals

or expectations, but even on irrational behavior and

events uncorrelated to a company’s business

Implicit expectations are baked into a multiple

Income Approach (DCF)

Can be tough determine the forecast horizon and

the many assumptions that go along with the model

Shorter horizon – Terminal Value contributes too much

to the Value of the company

Longer horizon – Greater chance for forecasting error

and will probably be outside of investment horizon

Could possibly be “garbage in, garbage out”

And is there a way to combine both of these methods for stock selection?

So How Can an Investor Gain A Competitive Advantage Without Falling

Into The Common Pitfalls For Equity Valuation?

By trying to understand potential returns the market expects from a stock for a

given investment horizon, and deciding if the market’s expectations are:

Too High,

Too Low, or

Just Right

From there, an investor can make a recommendation as to if a stock is truly under-,

over-, or fairly valued

So How Can We Understand The Market’s Expectations?

Can potentially be done by using the Present Value of Growth Opportunities

(PVGO) Thought Process:

𝑽𝒂𝒍𝒖𝒆 𝑭𝒊𝒓𝒎 = 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑭𝒊𝒓𝒎𝒘𝒊𝒕𝒉 𝑵𝒐 𝑮𝒓𝒐𝒘𝒕𝒉 + 𝑮𝒓𝒐𝒘𝒕𝒉 𝑬𝒙𝒑𝒆𝒄𝒕𝒂𝒕𝒊𝒐𝒏𝒔

PVGO Thought Process

Based off of the Gordon Growth Model, using this train of thought can help an investor understand

the market’s expected returns for a given stock and weigh it against the risk

Goal of this process is to find stocks of companies that have low growth expectations relative to an

investor’s assessment of a company’s risk and potential returns

𝑽𝒂𝒍𝒖𝒆 𝑭𝒊𝒓𝒎 𝒕 =𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝑩𝒆𝒏𝒆𝒇𝒊𝒕𝒕+𝟏

𝑫𝒊𝒔𝒄. 𝑹𝒂𝒕𝒆−𝑮𝒓𝒐𝒘𝒕𝒉 𝑹𝒂𝒕𝒆𝑽𝒂𝒍𝒖𝒆 𝑭𝒊𝒓𝒎 𝒕 =

𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝑩𝒆𝒏𝒆𝒇𝒊𝒕𝒕

𝑫𝒊𝒔𝒄. 𝑹𝒂𝒕𝒆+ 𝑷𝑽𝑮𝑶

Three Main Components Of The PVGO Thought Process

1. The Economic Benefit

I. Which “benefit” will be used? EPS, FCF, Dividends, EBITDA, Pretax Profits, etc.

II. Directly finding Equity Value or indirectly by finding the value of the enterprise first?

III. Timeframe of past “benefit”? LTM, 3 or 5 year average, weighted averages, etc.

2. The Discount Rate / Cost of Capital

I. CAPM

II. Build-up Model

III. Cost of Debt plus Risk Premium

3. Growth Expectations (PVGO %)

I. Past trends in growth and margins for the economic benefit used

II. Potential size of a company’s industry

III. Current part of Company/Industry life cycle

IV. Competitive Analysis

V. Other Fundamental Analysis

How PVGO Relates To A Company’s Risk Within Their Life Cycle

PVGO, Discount Rates, and the Corporate Life Cycle

Growth Stage Start-up Young Growth High Growth Mature Growth Mature Stable Decline

Description Business ideaCreate business

modelBuild the business, creating revenues

Grow business via operating leverage,

create profitability

Defend business from new competitors and

marketsScale down business, consolidate

InvestingOption Investing (go

for upside)

Growth Investing

(maximize value from

growth)

Scaling Investing (scale up growth)Defensive Investing (protect the

competitive advantage)Maintenance Investing (preserve value) Divesting (shed past investments)

Financing All Equity All EquityFirst signs of debt capacity, but little

to no benefits

Debt capacity expands, and the benefits

of borrowing will start to exceed the

costs

Benefits of borrowing significantly exceed

costsPay down debt as assets are sold

Revenues None

Finding first

customers, may need

to "grow at all costs"

to gain traction

Revenue growth increases rapidly,

possibly even doubling every year

Revenue growth starts to slow down, but

still growing faster than the broad market

Revenues are more in line with the rest of

the broad market, as competitors start to

saturate the market

Revenues start to decline; only way to grow

significantly is via M&A

Profits / CF NoneCash burn is

extremely high

Signs of profitability start to appear

as losses decrease; business is close

to being CF positive

Profitability starts to grow significantly via

operating leverage

Profitability growth starts to slow down;

business may start to accumulate cash on

hand

Profitability drops off dramatically, as assets are

sold, decreasing the business's earnings power

Value Driver

(Economic

Benefit)

Market Potential

Key Performing

Indicators / Operating

Data

Revenue / Gross Cash Flow Adj. Cash Flow / EBIT / EBITDA Free Cash Flow / Net Earnings Book Value / invested Capital / Dividends

Discount Rate

(Cost of

Equity)

Extremely high, as the

chance of failure is

very high (>40%)

Still very high, as the

business model is still

uproven (30-40%)

Not as high as before since the

business model has gained traction,

but still high due to little to no

profitability (25-30%)

As the business begins to grow profits

and cash flows, the question now is if the

business can be scaled up; returns are still

expected to be higher than the broad

market (15-25%)

As revenues become more in line with the

rest of the broad market, so too should

investor's expectations for returns, as the

business's operational results start to

become more predictable (7-15%)

Investor expectations aligns with what growth

within the entire sector and the overall economy

(4-7%)

PVGO %

Well above 100%, if

not closer to 1000%

due to the market

potential

Still well above 100%;

must start paying

attention to

investments and

understand how

they'll enhance value

Still at or around 100%, especially if

the business is close to or just

becoming profitable

PVGO finally starts to decline, as the

business starts to reach it's potential

from a profitability standpoint; dividends

may start to come into play (50-90%)

Similar to Revenues and the discount rate,

PVGO starts to align with the broad market

as well (25-50%)

PVGO is below the market, as profits are

expected to continue to decrease; may start to

expect dividends to drive PVGO more than

growth in profits (0-25%)

How PVGO Relates To A Company’s Risk Within Their Life Cycle (Cont.)

Time

Growth in Revenues and Profits Throughout the

CLC

Revenues Profits0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0%

50%

100%

150%

200%

250%

Time

Discount Rate and PVGO % Throughout CLC

PVGO (LHS) Discount Rate (RHS)

Young Growth

Young

Growth

Start-up

Start-up

High

Growth

High

Growth

Mature

GrowthMature

Growth

Mature

Stable

Mature

Stable

Decline

Decline

PVGO THOUGHT PROCESS IMPLEMENTATION

Understanding The PVGO Thought Process – The S&P 500 Since 1990

Data is sourced from Aswath Damodaran’s Implied Equity Risk Premiums (by year) from his website

YearDividend

YieldS&P 500 Earnings* Dividends*

Change in

EarningsT.Bond Rate

Implied Premium

(FCFE)

Disc.

Rate

EPS/Disc.

Rate

% No

Growth% PVGO

1990 3.74% 330.22 22.65 12.35 -6.87% 8.07% 3.89% 11.96% 189.38 57.35% 42.65%

1991 3.11% 417.09 19.30 12.97 -14.79% 6.70% 3.48% 10.18% 189.59 45.45% 54.55%

1992 2.90% 435.71 20.87 12.64 8.13% 6.68% 3.55% 10.23% 204.01 46.82% 53.18%

1993 2.72% 466.45 26.90 12.69 28.89% 5.79% 3.17% 8.96% 300.22 64.36% 35.64%

1994 2.91% 459.27 31.75 13.36 18.03% 7.82% 3.55% 11.37% 279.24 60.80% 39.20%

1995 2.30% 615.93 37.70 14.17 18.74% 5.57% 3.29% 8.86% 425.51 69.08% 30.92%

1996 2.01% 740.74 40.63 14.89 7.77% 6.41% 3.20% 9.61% 422.79 57.08% 42.92%

1997 1.60% 970.43 44.09 15.52 8.52% 5.74% 2.73% 8.47% 520.54 53.64% 46.36%

1998 1.32% 1,229.23 44.27 16.20 0.41% 4.65% 2.26% 6.91% 640.67 52.12% 47.88%

1999 1.14% 1,469.25 51.68 16.71 16.74% 6.44% 2.05% 8.49% 608.72 41.43% 58.57%

2000 1.23% 1,320.28 56.13 16.27 8.61% 5.11% 2.87% 7.98% 703.38 53.28% 46.72%

2001 1.37% 1,148.09 38.85 15.74 -30.79% 5.05% 3.62% 8.67% 448.10 39.03% 60.97%

2002 1.83% 879.82 46.04 16.08 18.51% 3.81% 4.10% 7.91% 582.05 66.16% 33.84%

2003 1.61% 1,111.91 54.69 17.88 18.79% 4.25% 3.69% 7.94% 688.79 61.95% 38.05%

2004 1.60% 1,211.92 67.68 19.407 23.75% 4.22% 3.65% 7.87% 859.97 70.96% 29.04%

2005 1.79% 1,248.29 76.45 22.38 12.96% 4.39% 4.08% 8.47% 902.60 72.31% 27.69%

2006 1.77% 1,418.30 87.72 25.05 14.74% 4.70% 4.16% 8.86% 990.07 69.81% 30.19%

2007 1.89% 1,468.36 82.54 27.73 -5.91% 4.02% 4.37% 8.39% 983.79 67.00% 33.00%

2008 3.11% 903.25 65.39 28.05 -20.78% 2.21% 6.43% 8.64% 756.83 83.79% 16.21%

2009 2.00% 1,115.10 59.65 22.31 -8.78% 3.84% 4.36% 8.20% 727.44 65.24% 34.76%

2010 1.84% 1,257.64 83.66 23.12 40.25% 3.29% 5.20% 8.49% 985.39 78.35% 21.65%

2011 2.07% 1,257.60 97.05 26.02 16.01% 1.88% 6.01% 7.89% 1,230.04 97.81% 2.19%

2012 2.13% 1,426.19 102.47 30.44 5.58% 1.76% 5.78% 7.54% 1,359.02 95.29% 4.71%

2013 1.96% 1,848.36 107.45 36.28 4.86% 3.04% 4.96% 8.00% 1,343.13 72.67% 27.33%

2014 1.92% 2,058.90 113.01 39.44 5.17% 2.17% 5.78% 7.95% 1,421.51 69.04% 30.96%

2015 2.11% 2,043.94 106.32 43.16 -5.92% 2.27% 6.12% 8.39% 1,267.22 62.00% 38.00%

Avg. 2.08% 7.02% 4.61% 4.09% 8.70% 731.92 64.34% 35.66%

Median 1.94% 8.33% 4.52% 3.79% 8.47% 696.09 64.80% 35.20%

What The PVGO Thought Process Can Tell Us About The Market Over

The Past 25 Years…

Since 1990, the average market participant could expect:

2% Dividend Yield,

7-8% EPS Growth,

8-9% Discount Rate based off of CAPM for Cost of Equity,

9-10% Discount Rate based off of GGM for Cost of Equity,

And 35% of the price based on future growth expectations

And What About The Typical Investor’s Time Horizon?

Based on the range of Discount Rates (7-10%), the PVGO Though Process shows that the typical investor’s time

horizon within the market is anywhere from 4-7 years

At a 7% Discount Rate

No-Growth %64%

PVGO %36%

$100 $55

Years 0 1 2 3 4 5 6 6.5

$100 $107 $114 $123 $131 $140 $150 $155


No-Growth %65%

PVGO %35%

$100 $54

Years 0 1 2 3 4 4.5

$100 $110 $121 $133 $146 $154

So What About The S&P 500 Index Now?

1. Economic Benefit Used

1. TTM EPS (1Q15-1Q16)

1. $98.61 – from S&P Dow Jones Indices - S&P 500 Earnings And Estimate Report, 7/7/16

2. Discount Rate Used

1. 1.53% - 10 Year U.S. Treasury Note for 7/14/16

2. 6.27% - (+) Implied ERP - TTM Cash Yield from Aswath Damodaran’s website

3. 7.80% - Discount Rate

3. PVGO %

1. $98.61 – TTM EPS

2. 7.80% - (/) Discount Rate

3. $1,264.23 – Market Value of S&P 500 with No-Growth Expectations

Implications of S&P 500’s PVGO Status

With the S&P 500 at $2,161.74 (7/15/16), the No-Growth value of the S&P 500 represents 58% of the market price, meaning 42% of the market price represents expected growth in value in the future

The PVGO % represents 20% CAGR over a 3 year investment horizon, or a 9% CAGR over a 5 year investment horizon

The key question to ask is are the implied growth rates of the market reasonable, too optimistic, or too pessimistic?

For comparison, the S&P 500 Earnings And Estimate Report from S&P Dow Jones Indices projects 23% EPS growth for the next twelve months, and 17% CAGR through the end of 2017

Don’t forget that the LT average for PVGO % is around 35%, for 8-10% annual rate of return when taking dividends into consideration, which is still yields around 2%, which accounts for 6% of the PVGO % for a 3 year horizon and 9% PVGO % for a 5 year horizon, and if share repurchases continue to happen, then EPS growth might not need to be as high to reach current market expectations


No-Growth %58%

PVGO %42%

$100 $73

Years 0 1 2 3

$100 $120 $144 $173


No-Growth %59%

PVGO %41%

$100 $69

Years 0 1 2 3 4 5

$100 $111 $123 $137 $152 $169

So What About Valuing a Company? McDonald’s (NYSE: MCD) Maybe…

1. Economic Benefit Used

1. TTM FCF in $MM (CFO – CAPX) (1Q15-1Q16)

1. $4,476 – from Morningstar’s Financial Calculations, 7/15/16

2. Discount Rate Used

1. 6.27% - (+) Implied ERP - TTM Cash Yield from Aswath Damodaran’s website

2. 0.52 - (x) MCD’s Beta from Google Finance and Zacks, 7/15/16

3. 3.26% - ERP for MCD

4. 1.53% - (+) 10 Year U.S. Treasury Note for 7/14/16

5. 4.79% - MCD’s Discount Rate

3. PVGO %

1. $4,476 – TTM FCF in $MM

2. 4.79% - (/) Discount Rate

3. $99,073.15 – Market Value of MCD with No-Growth Expectations ($MM), or ~$112/Share

Implications of MCD’s PVGO Status

With MCD having a market cap of at $109,409 MM, or ~$124/share (7/15/16), the No-Growth value of MCD represents 91% of the market price, meaning only 9% of the market price represents expected growth in value in the future

The PVGO % represents about 3.5% CAGR over a 3 year investment horizon, or a 2% CAGR over a 5 year investment horizon

The key question to ask again is are the implied growth rates of the market reasonable, too optimistic, or too pessimistic?

Remember, MCD is currently paying a near 3% dividend yield, which means that there has to be plenty of FCF to distribute, in which there is based on MCD’s overall franchising strategy and 15-19% FCF margin, essentially being a Cash Cow

If any growth in FCF or FCF margin happens in the near future, MCD will be well worth the investment, especially if a potential investor believes that MCD expanding their all-day breakfast menu will lead to more cash flow for dividend growth, or higher growth expectations, which will lead to multiple expansion and appreciation in MCD’s stock price

This may lead an investor to think that the market expectations are too pessimistic, unless fears from slower international sales from Brexit, or if U.S. same-store sales growth becomes stagnant because customers might not react well to MCD increase prices and having higher-quality food will slowdown FCF generation

At a 3.5% Discount Rate

No-Growth %90%

PVGO %10%

$100 $11

Years 0 1 2 3

$100 $104 $107 $111


No-Growth %91%

PVGO %9%

$100 $10

Years 0 1 2 3 4 5

$100 $102 $104 $106 $108 $110

Conclusion

The PVGO Thought Process can be used as an attempt to quantify the market’s growth expectations for a stock

Can lead to higher accuracy in forecasting economic benefits and understanding investor sentiment for a

company’s stock

Can also be used to understand what stage the market may think a company is at in their Corporate Life Cycle

This process is best used for investors that fully understand the major inputs:

1. Economic Benefit

2. Discount Rate

3. PVGO % of the company relative to it’s own history and peers

4. An investor’s time horizon

Key Resources

Expectations Investing: Reading Stock Prices for Better

Returns by Michael J. Mauboussin – CFA Publications

(September 2006)

Fundamental Analysis and Market Prices Presentation for

the OIV Conference by Stephen Penman

Aswath Damodaran’s website and publications

New Construct’s website

Valuation: Measuring and Managing the Value of

Companies: Fourth Edition – by Tim Koller, Marc

Goedhart, and David Wessels

Understanding Business Valuation – by Gary R. Trugman

Best Practices for Equity Research Analyst and

AnalystSolutions website by James Valentine

Morningstar’s website

Zacks’ website

Marketwatch’s website

Barron’s website

Federal Reserve Economic Data

S&P Dow Jones Indices

pvgo thought process for equity valuation

Economy & Finance