Principles of Finance/Section 1/Chapter 6/Corp/PVGO

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 $P_0=\frac{EP{S}_1}{r}+PVGO$)

$g=plowback*ROE$