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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Net Present Value of Growth Opportunities (NPVGO)

What it is:

Net Present Value of Growth Opportunities (NPVGO) is the simply the present value of additional cash flows associated with an acquisition, net of the purchase price of the acquisition. Essentially, the concept adds the present value of assets in place to the present value of the company's growth prospects. The required rate or return is typically the acquirer's weighted average cost of capital.

In general, the formula for NPVGO is:

NPVGO = Cost of investment [(profit margin or rate of return on acquisition-growth rate) / (cost of capital-profit margin or return on acquisition)]

How it works (Example):

Let's assume Company XYZ is considering purchasing Company ABC. The shares of ABC are earning $1 per share and are trading at $20 per share. Company XYZ expects ABC's earnings to grow at 10% per year. If Company XYZ's required rate of return is 8%, then the net present value of purchasing Company ABC shares is:

NPVGO = $20 [(0.05 - 0.10) / (0.08 - 0.05)] = $33.33 per share

Why it Matters:

Similar to the way the dividend discount model is used to determine the "correct" price of a stock based on its projected future cash flows, NPVGO is a way to determine the incremental value of a new project or acquisition. Additionally, NPVGO can be used to set the price or negotiate the price of a project or acquisition. It can also be used to derive what value the market is giving to future growth for a certain stock or company.

However, the calculation is based on projections, which means those projections can be highly influential in key decisions, and the analyst must be sure to exclude nonrecurring earnings, earnings from discontinued operations and other nonstandard cash flows.

It is important to compare NPVGO in the context of a particular industry. Capital requirements, technology and other situations tend to be very industry-specific and thus the definition of high or low NPVGO should be made within this context.

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