PVGO ==> E1 or E0 ??

CFA Level II
#1

Hello, I have been looking for a clear answer on the forum but people just argue with each other. THe formula for PVGO V=E1/r + PVGO Now, I did the mocks from the CFA wesbite and sometimes they use E0 and not E1. And sometimes they use E0(1+g)=E1. So how do I know which one to use? Thank you

#2

E1 is the one I would use.

#3

you might find my explanation here useful

http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91351395

#4

No that’s not helpful but thanks. I still dont know when to use E1 or E0. I get the idea of no growth… There are still instances where CFAI deliberatly calculates E1 and some where they just get E0.

#5

The value of any asset is always based on future cash flows, if you have this concept clear, I dont think you will get confused anytime

Can you suggest me any examples to see where CFAI deliberately calculates E1?

#6

It’s definitely E1, but if you’re referring to the online CFAI topic questions, there is definitely an error on one of their PVGO problems where they use E0.

#7

Hi, No it is not an error. They do the same thing in the CFA book. Look at EOC question 8) C) in the DIvidend Discount Valuation Chapter in Eauity. In this case they use E0.

#8

Hi,

CFA online question in Equity: Case name: Mendosa ==> they use E1

Case Name Vitality ==> They use E0

CFA book Quesiton 8C in the DIvidend Valuation CHapter; THey use E0

#9

Lol CFA pissing me off lately. I can’t answer that now that you pointed out 8C as well.

#10

lol =)

#11

I noticed this as well but didnt go as in depth in looking into it. I think the calc doesnt work if you use E1 so after a long time of scratching my head I threw E0 in there and an answer popped out so I went with that

#12

I did the two topic tests.

First of all it is very clear that it will be E1 because value is always based on future cash flows , however at the same time when there is no growth E1=E0. When there is no growth earnings will grow at the rate of ZERO and hence the earnings remain the same ( unless in the question E1 is explicitly stated but if you have to use E0 to get E1 for a zero growth company, E1=E0)

In the case of Mendosa, i must say that the calculation is wrong imho for the following reasons

  • recent EPS = 5.33
  • If you assume that there is no growth, that implies no reinvestment and hence all earnings will be paid as dividends.
  • So E1 = E0 ( 1+g) where g=0 because we have assumed no growth
  • So it should be 5.33/0.124 and NOT 5.33 *(1.15)/0.124 .
  • This is very consistent with the EOC example 8. I quote what the book say in part C : if the company was a no growth company, that is it paid out all its earnings as dividends and did not reinvest, its earnings would stay the same. The value of such a company would be the value of perpetuity = D/r = E/r = 2/0.11
  • The same argument holds here, When the recent EPS is 5.33, how can you grow at 15% to get E1. E1 will be the same as E0 which is equal to 5.33 ( unless I am missing anything written in the case)

hope that helps

#13

Hi Saurabm,

Nice explanation. But one thing regarding Mendosa. In the table with the growth rate, they do specify that Earnings and Dividends will grow by g, that is 15%. THat’s the only difference I can see. They clearly state it. Other cases are not that explicit and they use E0.

#14

If you read the curriculum, you’ll see that they use E1.

It’s unfortunate that you see this contradiction in the questions from CFA Institute. I’m going to write them and see if I can get them to correct it. It’s awful.

#15

Hi Mark666,

Thats my point. that 15% growth is when you reinvest back into the company. If you do not reinvest, the growth is 0. Growth is not free.

You cannot grow when you pay all your earnings as dividends.

#16

Oh ok I see sorry.

#17

HI Magician, It would be great if you could write to them :slight_smile: I am too busy studying right now :frowning: THanks

#18

Just figured I’d add to this conversation again since I ran into anther PVGO practice problem last night. Schweser Mock Volume 2 Exam 2, page 117.

You’re given current earnings, expected earnings, required return on equity. They use E1 in this problem, as curriculum’s formula says, but by the same logic as above, if the above answers are correct and there is growth between E0 and E1, it seems the above answers imply E0 would be the correct number for this problem. Anyways, just figured I’d reference another problem. Come exam day, if I run into any of PVGO problems, I’ll check to see if E1 and E0 are both valid choices (they probably will be because CFA exam writers are savage lol), but I’m going to stick w/ the formula as given. If they do something like this come exam day and give both options as answers and they say E0 is correct, I’d imagine a large portion of people would get it wrong and then when they reviewed the exam to create the MPS it would be tossed out. Just my thoughts.

#19

Sheesh just came across this again in Mendosa. I’m going E1 - fingers crossed.

#20

Look at it logically. You are basically discounting a perpetual cash flow. Your value is at t=0 and pvgo is calculated for t=0. If you use E0/r the PV you will get will be for T=-1, but you want it for t=0, hence we use E1/r. In the exam I would suggest use E1, if any of the options do not represent that answer then use E0.