Technically, it’s either, but go with E1/r for the sake of the exam. Remember, with the PVGO formula, all earnings are paid out as dividends. Therefore, E1 = D1.
The formula IS confusing to me, though. If E1/r is no-growth, E1 shouldn’t be E0 * (1+g), but I digress…
Hi, i’m trying to understand the logic behind this formula of a company with no growth. V0 = E1/r how does dividing your EPS by your required rate of return become your valuation? It sounds like just discounting your earnings by 1 year?
The formula is saying to you that the company will be paying into perpetuity all of its earnings (the model assumes earnings to be the same each consecutive year, that is why E1 (which = D1). It is the same principle as how we value a non-callable fixed paying preferred share or a perpetuity payment (from Quant L1), that is, cash flow/rate.
V0= E1/(Ke-g) … but they have zero growth (g= 0) because they have no investment opportunities to create shareholder wealth (positive NPV projects), therefore the company is paying all of its earnings to common shareholders, that is a dividend payout ratio of 100%.
Thanks, it’s been a couple years since i took lvl1 so a bit rusty.
I also looked up more on perpetuity and also helped to know the original summation formula is essentially an infinite geometric series that converges to simplify to the E1/r.