VALUATION OF A FIRM

Case Problem Ideko is a privately held designer and manufacturer of specialty sports eyewear based in Chicago. In mid 2005 its owner and founder June Wong has decided to sell the business after having relinquished management control four years earlier. PKK investments is investigating the purchase of the company at the end of the current fiscal year. PKK plans to implement operational and financial improvements at Ideko over the next five years, after which it intends to sell the business. This case was shamelessly stolen from the text Corporate Finance by Berk and DeMarzo

Ideko Ideko has assets of $87 million and annual sales of $75 million. The firm has earnings of almost $7 million for a profit margin of 9.3%. The owner is looking for $150 million as a sales price, almost double the book value of equity. The question: Is such a valuation reasonable?

Ideko – 2005 Income Statement and Balance Sheet.

Valuation Multiples for Proposed Transaction P/E = 150/6.94 EV/Sales = (150+4.5-6.5)/75 EV/EBITDA = (150+4.5-6.5)/16.25 Note: EV is enterprise value which is equity value plus debt value less excess cash ($6.5 M)

What equity valuations are implied? Example: For the low EV/Sales valuation the implied equity Value = 1.4*75+6.5-4.5=107.0 We would like to purchase for as low a price as possible. based on the multiples, an equity purchase price of $150 million is in the low end of the valuation ranges.

The Business Plan Operational Improvements By cutting administrative costs and redirecting resources to new product development, sales, and marketing, you believe Ideko can increase its market share from 10% to 15% over the next 5 years. The total market is expected to grow by 5% per year for that period. Ideko’s average selling price is forecast to increase 2% each year (this is expected inflation). Raw materials prices are forecast to increase at a 1% rate. Labor costs are forecast to increase at a 4% rate.

The Business Plan (cont'd) Operational Improvements The increased sales demand can be met in the short run using the existing production capacity. Once the growth in volume exceeds 50%, however, Ideko will need to undertake a major expansion to increase its manufacturing capacity.

Capital Expenditures and Needed Expansion Production volume reaches the breaking point, a 50% increase, in 2008 requiring an expansion of capacity at that time.

Capital Expenditures and Needed Expansion In 2008, a major expansion will be necessary, leading to a large increase in capital expenditures in 2008 and 2009. The estimated expenditures are: For simplicity, depreciation is assumed to be 10% of the sum of opening book value plus new capital expenditures.

Sales and Operating Cost Assumptions

Building the Financial Model The total value of a firm, VF, equals the present value of the free (net) cash flows, FCF, that the firm is expected to provide investors, discounted by the firm’s weighted average cost of capital, WACC. The total free cash flows are calculated as follows: Sales - Operating Expenses Earnings Before Interest, Taxes, Dep & Amort (EBITDA) - Depreciation and Amortization Operating Profit (EBIT) x (1 - Average Tax Rate) Operating Profits After Tax + Depreciation and Amortization - Capital Expenditures - Additions to Working Capital Free Cash Flows where: t is the period in which the cash flow is received.

Building the Financial Model The total value of the firm consists of: VF = PV(FCFT) + PV(TVT) + NOA where: V - value of the business PV(FCFT) - PV of the total FCF through year T PV(TVT) - PV of the terminal value in year T NOA - market value of excess or non-operating assets (here, cash)

Building the Financial Model Just as total assets equals total liabilities plus shareholders’ equity in accounting, in finance: Firm Value = Value of Equity + Value of Debt Or, VF = VE + VD This relation suggests that we can estimate the value of the firm directly by valuing the assets, or indirectly by valuing (and then summing) the claims on those assets.

Building the Financial Model Forecasting Earnings To build the pro forma income statement, begin with Ideko’s sales. Each year, sales can be calculated as: The raw materials cost can be calculated from sales as:

Building the Financial Model Forecasting Earnings Sales, marketing, and administrative costs can be computed directly as a percentage of sales. The corporate income tax is computed as:

Pro-Forma Income Statement Note that we ignore financing cash flows (interest). The effects of financing are accounted for in the WACC.

Working Capital Management Ideko’s Accounts Receivable Days is: While the industry average is 60 days You believe that Ideko can tighten its credit policy to achieve the industry average without sacrificing sales.

Working Capital Management… Ideko’s inventory figure on its balance sheet includes $2 million of raw materials. Given raw material expenditures of $16 million for the year, Ideko currently holds 45.6 days worth of raw material inventory. (2 ∕16) × 365 = 45.6 You believe that, with tighter control of the production process, 30 days worth of inventory will be adequate.

Working Capital Management… Note that all quantities are stated in days and are based on different income statement items.

Working Capital Requirements The working capital forecast should include the plans to tighten Ideko’s credit policy, speed up customer payments, and reduce Ideko’s inventory of raw materials. Accounts Receivable in 2006 is calculated as:

Working Capital Requirements (cont'd) The minimum cash balance is the minimum level of cash needed to keep the business running. Firms typically earn little or no interest on these balances. As a consequence, the opportunity cost of holding cash is accounted for by including the minimal cash balance as part of the firm’s working capital.

Working Capital Forecast Note that the cash flows associated with working capital are the changes in net working capital from year to year.

Forecast of Free Cash Flow The definition of free cash flow (FCF) is unlevered net income, plus depreciation, less changes in net working capital, less net capital expenditures.

Capital Structure Changes: Levering Up You believe Ideko is significantly underleveraged so you plan to increase the firm’s debt. You believe that a debt-to-value (D/(E+D)) ratio of 40% is appropriate. With this capital structure, you believe that the debt will be risky and will have a beta of 0.25.

Estimating the Cost of Capital CAPM-Based Estimation Since Ideko is not publicly traded, comparable firms must be used to estimate the firm’s beta. The beta for comparable firms is calculated from the regression:

Beta Estimates

Unlevering Beta Given an estimate of each firm’s equity beta, the “unlevered” beta must be calculated, based on the firm’s capital structure.

Ideko’s Unlevered Beta The data from the comparable firms provides guidance for estimating Ideko’s unlevered cost of capital. Ideko’s products are not as high end as Oakley’s eyewear, so Ideko’s sales are unlikely to vary as much with the business cycle as Oakley’s sales do. Ideko does not have a prescription eyewear division, as does Luxottica. Ideko’s products are fashion items rather than exercise items.

Ideko’s Levered Beta Given the above analysis, Ideko’s cost of capital is likely to be closer to (but less than) Oakley’s than it is to Nike’s or Luxottica’s. You decide to put 50% weight on the beta of Oakley, and 25% on Luxottica and Nike. Based on this you decide on 1.28 as your estimate for Ideko’s unlevered beta. Now relever this beta to reflect the 40% debt to value ratio that will be applied after the acquisition. Remember that you expect a debt beta of 0.25.

Ideko’s WACC Assume that the current risk-free interest rate is 4% and that you believe a market risk premium of 5% is appropriate. Ideko’s cost of equity is: Ideko’s cost of debt is:

Ideko’s WACC Ideko’s tax rate is 35%. Ideko’s WACC is:

Continuation Value We have forecast the cash flows out to year 2010 (five years) However, we need to estimate the value of all of the cash flows to be received after 2010. We could continue to forecast pro-forma statements, but this would be difficult. Instead, we forecast cash flows explicitly up to the point we believe the business will reach a steady state of growth and then summarize the remaining cash flows in what is called the continuation (or terminal) value.

Continuation Value The Multiples Approach to Continuation Value Practitioners often estimate a firm’s continuation value (also called the terminal value) at the end of the forecast horizon using a valuation multiple, with the EBITDA multiple being the multiple most often used in practice.

Continuation Value (cont'd) The Multiples Approach to Continuation Value One difficulty with relying on comparables when forecasting a continuation value is that future multiples of the firm are being compared with current multiples of its competitors. This is especially problematic if the industry is presently in a phase of either rapid growth or decline.

The Discounted Cash Flow Approach to Continuation Value The enterprise value in year T, using the WACC valuation method, is calculated as: Free cash flow in year T + 1 is computed as:

The Discounted Cash Flow Approach to Continuation Value (cont'd) If the firm’s sales are expected to grow at a nominal rate g and the firm’s operating expenses remain a fixed percentage of sales, then its unlevered net income will also grow at rate g. Similarly, the firm’s receivables, payables, and other elements of net working capital will grow at rate g.

The Discounted Cash Flow Approach to Continuation Value (cont'd) If capital expenditures are defined as: Then free cash flows, given g, can be estimated as: Or, sometimes it is simply assumed that free cash flow grows at rate g:

Ideko’s continuation value (DCF approach) In 2010 unlevered net income is $15,849, the level of working capital is $40,425 and the level of fixed assets is $69,392. Assume that you believe the business can grow at 5% per year indefinitely after 2010. The average growth rate in nominal GDP is a good starting point for such a growth rate. The free cash flow in 2011 is: FCF2011=15,849*(1.05)-40,425*(0.05)-9,392*(0.05)= $11,151

Ideko’s continuation value (DCF approach) FCF at 2011 is $11,151, the WACC is 9.67% The continuation (terminal) value (in $000’s) is: Note this implies an EBITDA multiple of 7.4x

Valuation of Ideko using WACC method PV of future cash flows from 2007 onward.

A Reality Check At this point, it is wise to step back and assess whether the valuation results make sense. Does an initial enterprise value of $172.2 million for Ideko (plus 6.5 million excess cash) seem reasonable compared to the values of other firms in the industry? Compute the initial valuation multiples that would be implied by our estimated enterprise value of $172.2+6.5 million and compare them to Ideko’s closest competitors.

Ideko Valuation Versus Comparables Example: P/E=174.8/6.9 EV/Sales=(172.2+6.5)/75 EV/EBITDA=(172.2+6.5)/16.25 The multiples are now near the top end of the range of the values of the other firms used for comparison. These multiples are not unreasonable given the operational improvements that PKK plans to implement, but they depend critically on PKK’s ability to achieve the operational improvements it plans.