Company Valuation Case Study

When Matt concocted his cleaning compound, some twenty years ago, all that his wife, Edith, and he were trying to do was to come up with a sweeter, gentler, yet tougher, cleaning product. Little did he realize that someday he would be the proud owner of a multi-million dollar firm debating whether or not to sell stock to the public?

After having peddled vacuum cleaners and floor wax products at state fairs and trade shows throughout the Midwest, Matt and Edith realized that there was a dire need for a cleaning and polishing product that was free from harsh chemicals, environmentally friendly, and tough on dirt and grime. So Matt spent many hours in his garage at their country home experimenting with various oils, cleansing agents, and extracts until he finally came up with what he proudly calls, "The perfect cleaner and polish" made from the peels of Valencia oranges. Not only was the mixture sweet smelling, it was an effective solvent and degreaser which worked wonders on their kitchen cabinets at home.

So spurred on by their close friends, the family formed their own company. Later with the help of their 3 children, Lisa, Dan, and Joe, they used direct response television, direct mail, and e-commerce channels to help grow the company's revenues at a phenomenal rate. When the Home Shopping Network agreed to let them show off their merchandise about 5 years ago, major retailers like Wal-Mart and Costco took notice and started stocking their product on their shelves.

Within twenty years, their sales had grown to over $500 million and their production facilities were beginning to feel the strain. Their product line had expanded to include air fresheners, soap bars, liquid soaps, spot removers, and a variety of cleaning tools. Through all this success, the family always focused on customer need and satisfaction, always encouraging their customers to provide them with feedback and testimonials. Their latest addition, i.e. an industrial-strength cleanser and wood protector, seemed to be gaining wide acceptance both in the United States and overseas.

Matt, who was nearing 75 years of age, knew that they would need to raise significant amounts of capital if they wanted to keep growing and expanding their product line. Still actively involved in the business, he had asked the rest of his family for their suggestions regarding the possibility of going public by issuing an initial public offering (IPO). Lisa and Joe strongly supported the idea because they felt that with competitors coming up with substitute products, they needed to stay ahead of the game. Dan, on the other hand, disagreed and recommended that they outsource the production and concentrate on their marketing efforts. He preferred that the firm stay private, thereby, relying less on external capital and retaining control.

After carefully weighing all the factors, Matt decided to explore the possibility of raising the money via an IPO. "Dan, Lisa, and Joe," he said, "the three of you have MBAs from some of the most prestigious business schools in the country. I hate to depend totally on the investment banking folks to come up with the right price. Why don't the three of you put your heads together and figure out what is the minimum price that we should sell our stock for if we were to go public. Let's say we sell 30 million shares. I'm sure we can find a way of retaining control of a large portion of the shareholding and still raise the much-needed cash. Dan's point of loss of control is a good one, but I am not in favor of outsourcing production. Our success has come from our quality and that would likely be jeopardized if we let others produce the product."

So Lisa, Dan, and Joe got to work. They realized that they would need industry and competitors' financial data. Table l presents key valuation data for 3 of their major publicly traded competitors in the personal and household products industry sector. Tables 2 and 3 present the companys 5-year income statements and balance sheets respectively.

Lisa preferred to use the Corporate Value Model whereby the firm's value was estimated as the sum of its discounted free-cash flows. Free cash flows were estimated by subtracting the firm's net capital investment from the year's net operating profits after taxes (NOPAT) and were discounted at a suitable risk-adjusted discount rate (weighted average cost of capital). Lisa assumed that the firm's free cash flows would grow at a rate of 20% during the first year, 10% during the second year, and finally settle down to a long-term growth rate of 6% thereafter. The firm's equity value was calculated by subtracting out the firm's outstanding debt owed to creditors from the overall value. Lisa used a risk-free rate of 3%, a market risk premium of 7%, and the average beta of the three competitors when determining the firm's cost of equity.

Having worked on various valuation projects for a major consulting firm, Dan was a strong advocate of the use of price-ratio models for valuing common stock. His method involved using suitable price-earnings, price-sales, price-book value, and price-cash flow multiples in conjunction with forecasted values for the firm's earnings, sales, book value, and cash flows respectively. Dan used the 4-year average compounded growth rate when forecasting the relevant variables and then discounted the year-ahead price forecasts by the required rate of return on equity (based on the Capital Asset Pricing Model using the same inputs that Lisa used).

Joe's old finance professor, Dr. Larry Brown, on the other hand, had indoctrinated him in the art of common stock valuation via the discounting of future dividends. "Always use a realistic required rate of return and various growth rate scenarios in conjunction with industry benchmarks, when valuing growth companies," was Dr Brown's advice. Accordingly, John decided to use a variable growth rate model to value the firms equity.

"What will we do if our three estimates are totally different?" asked Lisa looking rather concerned.

"We'll have to go back to the drawing table and examine our inputs," said the ever-resourceful Dan, "We'll each have to be within a reasonable ballpark, or Dad's going to flip!"

Questions

1. What are the advantages and disadvantages of going public? Do you agree with Dan's concerns or do you concur with the other members of the family regarding the issuance of an IPO? Explain why.

2. Comment on Lisa's preference of the Corporate Value Model. Based on her approach, what would the companys selling price per share be if they were to issue 30 million shares?

3. How does Lisa's price estimate compare with Dan's price estimate based on the price-ratio models? What are the pros and cons of Dan's preferred approach?

4. How far off would Joe's price estimate if he were to use a 3-stage approach with growth assumptions of 30% for the first 3 years, followed by 20% for the next two years, and a long-term growth assumption of 6% thereafter. Assume that the firm pays a dividend of $1.25 per share at the end of the first year. (worth 20 points)

5. Based on all three estimates and on the valuation figures for the three competitors how much per share do you think the company is really worth? Explain your rationale.

For Question 2: need to determine CAPM, WACC, finding free cash flow zero, free cash flow periods and horizon value, NPV, and stock price.

For Question 3: determine 4 year compounded growth rate, forecasting sales for 2005, comparable averages of ratios, average stock price, and stock price

For Question 4: determining time periods, and horizon value, and stock price.

BALANCE SHEET
	2000	2001	2002	2003	2004
Current Assets	$ 25,049,832.00	$ 39,000,000.00	$ 45,573,081.00	$ 57,621,600.00	$ 64,687,500.00
Fixed Assets	$ 30,616,462.00	$ 36,000,000.00	$ 42,067,459.00	$ 70,426,400.00	$ 97,031,250.00
Total Assets	$ 55,666,294.00	$ 75,000,000.00	$ 87,640,540.00	$ 128,048,000.00	$ 161,718,750.00
Current Liabilities	$ 4,329,601.00	$ 4,600,000.00	$ 3,128,108.00	$ 8,609,600.00	$ 13,343,750.00
Long-Term Debt(15%)	$ 26,336,694.00	$ 18,400,000.00	$ 12,512,432.00	$ 34,438,400.00	$ 53,375,000.00
Owner's Equity	$ 25,000,000.00	$ 52,000,000.00	$ 72,000,000.00	$ 85,000,000.00	$ 95,000,000.00
Total Liabilities & Owner's Equity	$ 55,666,295.00	$ 75,000,000.00	$ 87,640,540.00	$ 128,048,000.00	$ 161,718,750.00
INCOME STATEMENT
	2000	2001	2002	2003	2004
Revenue	$ 100,700,000.00	$ 225,000,000.00	$ 300,250,000.00	$ 400,150,000.00	$ 500,000,000.00
COGS(excluding depreciation)	$ 45,315,000.00	$ 108,000,000.00	$ 147,122,500.00	$ 184,069,000.00	$ 255,000,000.00
Gross Profit	$ 55,385,000.00	$ 117,000,000.00	$ 153,127,500.00	$ 216,081,000.00	$ 245,000,000.00
Depreciation	$ 3,061,646.00	$ 3,600,000.00	$ 4,206,746.00	$ 7,042,640.00	$ 9,703,125.00
Operating Expenses	$ 33,231,000.00	$ 72,000,000.00	$ 87,072,500.00	$ 141,653,100.00	$ 140,000,000.00
Earnings Before Interest & Taxes	$ 19,092,354.00	$ 41,400,000.00	$ 61,848,254.00	$ 67,385,260.00	$ 95,296,875.00
Interest Expense	$ 1,743,025.00	$ 2,760,000.00	$ 1,876,865.00	$ 5,165,760.00	$ 8,006,250.00
Earnings Before Taxes	$ 17,349,329.00	$ 38,640,000.00	$ 59,971,389.00	$ 62,219,500.00	$ 87,290,625.00
Income Taxes	$ 6,939,731.00	$ 15,456,000.00	$ 23,988,556.00	$ 24,887,800.00	$ 34,916,250.00
Net Income	$ 10,409,598.00	$ 23,184,000.00	$ 35,982,833.00	$ 37,331,700.00	$ 52,374,375.00
COMPARABLE RATIO
	Company A	Company B	Company C
Price/Earnings	23.6	24.6	22.8
Price/Book	8.7	12.1	4.2
Price/Sales	2.9	2.8	2.9
Price/Cash Flow	12	16.7	14.7
Dividend Yield %	2.0	1.6	1.7
Beta	1.2	1.3	1.15
Recent Price	$ 62.47	$ 57.29	$ 57.30