What it means
Imagine a company that earns steady profits and pays them all out to shareholders, never investing in anything new. Its shares would be worth roughly its earnings per share divided by the return investors require.
NPVGO is whatever extra value investors are willing to pay on top of that figure because they expect the company to find new projects that earn more than they cost. The key phrase is net present value (the value today of a project's future cash flows, after subtracting what it costs).
A growth opportunity only adds to NPVGO if it earns more than the required return. Growth for its own sake, such as spending heavily to expand into projects that barely earn their cost of capital, adds nothing and can even reduce value.
Analysts use NPVGO to judge how much of a share price is justified by the current business and how much depends on future success. A company with a high NPVGO share of its price is, in effect, priced on its promise rather than on what it already earns.
That makes the share more sensitive to disappointments, because investors can mark it down quickly if the growth plans stall. The concept is also helpful when comparing types of company.
A mature utility with few new projects is likely to have a low NPVGO, while a fast-growing software business reinvesting at high returns may have a large one. Neither is better or worse by itself; the point is to understand what you are paying for.
The calculation depends on estimates of future project returns, which are uncertain. A small change in the assumed required return or in the expected profit from new projects can shift NPVGO sharply, so it works best as a way of framing a valuation question rather than as a precise measurement.
In practice
Real-world examples.
Example
An analyst values a mature packaging manufacturer that earns $4 per share and has few new projects. At a 10% required return the no-growth value is $40, and the shares trade at $41, so the market is assigning only $1 per share to growth opportunities.
Example
A medical device company earns $2 per share but trades at $50 because it has a pipeline of new products. At a 10% required return the no-growth value is $20, so $30 of the price, or 60%, is NPVGO, and the analyst notes the share is highly sensitive to trial results.
Example
A retail chain proposes a $12,000,000 expansion of new stores that is expected to be worth $15,000,000 in present value terms. The NPV of the project is $3,000,000, and the chain's finance director counts this as part of its NPVGO.
Formula
Calculation
Share price = Earnings per share / Required return + NPVGO per share
Rearranged: NPVGO per share = Share price - (Earnings per share / Required return)
Suppose a company expects earnings of $5 per share, investors require a return of 10%, and the shares trade at $65. The no-growth value is $5 / 0.10 = $50 per share. NPVGO per share = $65 - $50 = $15. With 4,000,000 shares in issue, the total NPVGO is $15 x 4,000,000 = $60,000,000, and growth opportunities account for $15 / $65 = about 23% of the share price.Case study
Seen in the real world.
Ashgrove Brewing is a fictional company with 10,000,000 shares and earnings of $3 per share. Its shares were trading at $50 while peers with similar earnings and no expansion plans traded at around $30. The chief executive believed the market was undervaluing the business, while the finance director wanted to understand exactly what investors were paying for.
Using a 10% required return, the finance director calculated a no-growth value of $3 / 0.10 = $30 per share. The remaining $20 per share, or $200,000,000 across all shares, was NPVGO, which meant investors were counting on the planned craft beer expansion to deliver real value.
In this illustrative story, the board then reviewed the expansion plan line by line and dropped two projects whose expected returns barely exceeded the required return. The share price held, and the board was clearer about which projects were creating value and which were just adding size.
Watch out
Common mistakes.
- Treating all growth as valuable. Growth only adds value when the new projects earn more than the required return.
- Using accounting earnings that are distorted by one-off items. The no-growth value is only meaningful if earnings per share reflects sustainable profit.
- Reading NPVGO as a precise number. It is a residual that depends on an assumed required return, so small input changes move it a lot.
Questions
People also ask.
What is a high NPVGO a sign of?
It suggests the market is pricing in substantial future opportunities, which can mean strong prospects but also higher risk if those opportunities do not arrive.
Can NPVGO be negative?
Yes, if the company is expected to invest in projects that earn less than the required return, the market price may fall below the no-growth value.
How does NPVGO relate to the price-earnings ratio?
A higher price-earnings ratio than the inverse of the required return usually signals that investors expect a positive NPVGO.
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