You are on page 1of 11

Week 8 Notes

Welcome to week 8! These are some concepts that will help you as you read through Case 45: JetBlue
Airlines IPO Valuation (pages 617-634) and with your assignment, Case 50: Flinder Valves and Controls
(pages 715-726). Please read through the notes below before reading the case, then read through the case,
then go through the case 45 notes.

An initial public offering (IPO) is the process through which a privately held company issues
shares of stock to the public for the first time. Also known as "going public," an IPO transforms a
small business from a privately owned and operated entity into one that is owned by public
stockholders. An IPO is a significant stage in the growth of many small businesses, as it provides
them with access to the public capital market and also increases their credibility and exposure.
Becoming a public entity involves significant changes for a small business, though, including a
loss of flexibility and control for management. In many cases, however, an IPO may be the only
means left of financing growth and expansion. The decision to go public is sometimes influenced
by venture capitalists or founders who wish to cash in on their early investment1.

Staging an IPO is also a very time-consuming and expensive process. A small business interested
in going public must apply to the Securities and Exchange Commission (SEC) for permission to
sell stock to the public. The SEC registration process is quite complex and requires the company
to disclose a variety of information to potential investors. The IPO process can take as little as
six months or as long as two years, during which time management's attention is distracted away
from day-to-day operations. It can also cost a company between $50,000 and $250,000 in
underwriting fees, legal and accounting expenses, and printing costs1.

Overall, going public is a complex decision that requires careful consideration and planning.
Experts recommend that small business owners consider all the alternatives first (such as
securing venture capital, forming a limited partnership or joint venture, or selling shares through
private placement, self-underwriting, or a direct public offering), examine their current and
future capital needs, and be aware of how an IPO will affect the availability of future financing1.

According to Jennifer Lindsey in her book The Entrepreneur's Guide to Capital, the ideal
candidate for an IPO is a small-to medium-sized company in an emerging industry, with annual
revenues of at least $10 million and a profit margin of over 10 percent of revenues. It is also
important that the company have a stable management group, growth of at least 10 percent
annually, and capitalization featuring no more than 25 percent debt. Companies that meet these
basic criteria still need to time their IPO carefully in order to gain the maximum benefits.
Lindsey suggested going public when the stock markets are receptive to new offerings, the
industry is growing rapidly, and the company needs access to more capital and public recognition
to support its strategies for expansion and growth1.

The main body of the registration statement is a prospectus containing detailed information about the company. the small business must then prepare an initial registration statement according to SEC regulations. The management analysis is perhaps the most important and time-consuming part of the IPO process.THE PROCESS OF GOING PUBLIC Once a small business has decided to go public. the company's attorneys remain in contact with the SEC in order to learn of any necessary changes. which means that the investment bank purchases all the shares itself. Once a lead underwriter has been selected. which is similar to best efforts except that the offering is canceled if all the shares are not sold. In it. During the review process. The attorneys for the underwriter draft all the agreements. There are three basic types of underwriting arrangements: best efforts. The former concerns the registration of IPOs with the SEC in order to protect the public against fraud. This section is typically worded very carefully and reviewed by the company's attorneys to ensure compliance with SEC rules about truthful dis-closure1. experience in the industry. then evaluate the bidders on the basis of their reputation. The financial printer handles preparation of the prospectus and other written tools involved in marketing the offering1. outlines registration and reporting procedures. The firm commitment arrangement is probably best for the small business. experience with similar offerings. record of post-offering support. Joubert recommended that small business owners solicit proposals from a number of investment banks. the first step in the IPO process is to select an underwriter to act as an intermediary between the company and the capital markets. the company's financial statements must be audited by independent accountants in accordance with SEC rules. while the latter regulates companies after they have gone public. the small business owners must simultaneously disclose all of the potential risks faced by the business and convince investors that it is a good investment. and firm commitment. and a financial printer. distribution network. which means that the investment bank does not commit to buying any shares but agrees to put forth its best effort to sell as many as possible. all or none. independent accountants. The next step in the IPO process is to assemble an underwriting team consisting of attorneys. The SEC rules regarding public stock offerings are contained in two main acts: the Securities Act of 1933 and the Securities Act of 1934. and sets forth insider trading laws. This audit is more formal than the usual accounting review and provides investors with a much higher degree of assurance about the company's financial position1. Also during this time. After putting together a team to handle the IPO. The accountants issue opinions about the company's financial statements in order to reassure potential investors. which can take up to two months. since the underwriter holds the risk of not selling the shares. Upon completion of the initial registration statement. that firm will form a team of other underwriters and brokers to assist it in achieving a broad distribution of the stock1. including its financial statements and a management analysis. . Other considerations include the bidders' valuation of the company and recommended share price1. it is sent to the SEC for review. and type of underwriting arrangement. while the attorneys for the company advise management about meeting all SEC regulations.

fund capital expenditure or even used to pay off existing debt. and it is permitted to continue for up to ten days after the official offering date. Although further expansion is a benefit to the company. Other activities taking place during this time include filing various forms with different states in which the stock will be sold (the differing state requirements are known as "blue sky laws") and holding a due diligence meeting to review financial statements one last time1. beginning on the official offering date and continuing for seven days. What are the advantages and disadvantages for a company going public? An initial public offering (IPO) is the first sale of stock by a company. there are both advantages and disadvantages that arise when a company goes public2. and the small business owners and top managers travel around to make personal presentations of the material in what are known as "road shows. the underwriter returns the funds to the investors1. Another advantage is an increased public awareness of the company because IPOs often generate publicity by making their products known to a new group of potential customers2. If the offering is terminated for any reason. This process is called pegging. During the offering period. that management cannot disclose any further information beyond that contained in the prospectus during the SEC review period. and file a final amendment to the registration statement. An IPO closes with the transfer of the stock. Technically. or selling up to 15 percent more stock when demand is high1. the actual sale of stock is supposed to become effective 20 days after the final amendment is filed. the underwriter meets with all parties to distribute the funds and settle all expenses. but the SEC usually grants companies an acceleration so that it becomes effective immediately. agree to a final offering price for the shares. This acceleration grows out of the SEC's recognition that the stock market can change dramatically over a 20-day period. the financial benefit in the form of raising capital is the most distinct advantage. but the terms of the offering are not yet completed. The company distributes a preliminary prospectus to potential investors. At that time the transfer agent is given authorization to forward the securities to the new owners. however.Throughout the SEC review period—which is sometimes called the "cooling off" or "quiet" period—the company also begins making controlled efforts to market the offering. . Small companies looking to further the growth of their company often use an IPO as a way to generate the capital needed to expand. The actual selling of shares then takes place. The lead investment banker supervises the public sale of the security. The investment bankers may also support the offering through overallotment. There are many advantages for a company going public. Capital can be used to fund research and development. The company then must address the comments. As said earlier. the investment bankers are permitted to "stabilize" the price of the security by purchasing shares in the secondary market. At the end of the cooling off period. the SEC provides comments on the initial registration statement. The SEC requires the filing of a number of reports pertaining to the appropriate use of the funds as described in the prospectus. After a successful offering." It is important to note.

so small business owners must be careful not to get carried away with the publicity. audit fees. This usually will happen during the underwriting process as the company works with an investment bank to weigh the pros and cons of a public offering and determine if it is in the best interest of the company2. Another advantage IPOs hold for small businesses is increased public awareness. and lenders. ADVANTAGES OF GOING PUBLIC The primary advantage a small business stands to gain through an initial public stock offering is access to capital. Many venture capitalists have used IPOs to cash in on successful companies that they helped start-up2. companies must evaluate all of the potential advantages and disadvantages that will arise. which may lead to new opportunities and new customers. investor relation departments and accounting oversight committees2. information about the company is printed in newspapers across the country. public companies often face many new challenges as well. is the cost of complying with regulatory requirements can be very high. They must also meet other rules and regulations that are monitored by the Securities and Exchange Commission (SEC). Besides the immediate infusion of capital provided by an IPO. The only reward that IPO investors seek is an appreciation of their investment and possibly dividends. This may lead management to perform somewhat questionable practices in order to boost earnings2. An IPO also may be used by founding individuals as an exit strategy.Subsequently this may lead to an increase in market share for the company. customers. In addition. especially for smaller companies. which may lead to improved credit terms1. the capital does not have to be repaid and does not involve an interest charge. . Public companies also are faced with the added pressure of the market which may cause them to focus more on short-term results rather than long-term growth. Those shares of equity can be sold as part of the IPO. Some of the additional costs include the generation of financial reporting documents. or on the open market sometime after the IPO. However. or the IPO is unlikely to be a success1. A related advantage of an IPO is that it provides the small business's founders and venture capitalists with an opportunity to cash out on their early investment. Public companies are regulated by the Securities Exchange Act of 1934 in regard to periodic financial reporting. it is important to avoid the perception that the owners are seeking to bail out of a sinking ship. Before deciding whether or not to go public. however. As part of the IPO process. A related advantage is that the public company may have enhanced credibility with its suppliers. Even with the benefits of an IPO. The actions of the company's management also become increasingly scrutinized as investors constantly look for rising profits. These costs have only increased with the advent of the Sarbanes- Oxley Act. One of the most important changes is the need for added disclosure for investors. There are a number of laws covering the disclosure of information during the IPO process. The excitement surrounding an IPO may also generate increased attention in the business press. More importantly. a small business that goes public may also find it easier to obtain capital for future needs through new stock offerings or public debt offerings. in a special offering. which may be difficult for newer public companies.

Employees who become part-owners through a stock plan may be motivated by sharing in the company's success. and take part in the personal marketing of the stock. In fact. and future plans. It is not possible to make decisions as quickly and efficiently when the board must approve all decisions. because it can offer stock rather than cash1. Large shareholders may seek representation on the board and a say in how the company is run. By diluting the holdings of the company's original owners. Even when the sale does take place. Other disadvantages involve the public company's loss of confidentiality. accounting services. Finally. DISADVANTAGES OF GOING PUBLIC The biggest disadvantages involved in going public are the costs and time involved. Paul G. fees for public relations to bolster the company's image. SEC regulations restrict the ability of a public company's management to trade their stock and to discuss company business with outsiders1.Yet another advantage of going public involves the ability to use stock in creative incentive packages for management and employees. going public also gives management less control over day-to-day operations. In addition. consult with investment bankers. Many people find this to be an exhaustive process and would prefer to simply run their company1. and the personal marketing "road show" by managers. out-of-pocket expenses for legal services. Public entities also face added pressure to show strong short-term performance. SEC regulations require public companies to release all operating details to the public. The effect of this discount is to transfer wealth from the initial investors to new shareholders1. including sensitive information about their markets. and shareholders and financial markets always want to see good results. most underwriters offer IPO shares at a discounted price in order to ensure an upward movement in the stock during the period immediately following the offering. plus ongoing legal. and to provide them with an incentive to perform well. Some of the major costs include the lead underwriter's commission. Joubert noted that a small business owner should not be surprised if the cost of an IPO claims between 15 and 20 percent of the proceeds of the sale of stock.000 and $250. they can stage a takeover and oust management. Another disadvantage is that an IPO is extremely expensive.02 percent filing costs with the SEC. This means that it will be easier for the company to enter into mergers and acquisitions. attorneys. Despite such expense.000 to prepare and publicize an offering. Earnings are reported quarterly. Experts note that a company's management is likely to be occupied with little else during the entire IPO process. it is not unusual for a small business to pay between $50. and accountants. An untold number of problems and conflicts may arise when everyone from competitors to employees know all about the inner workings of the company. which may last as long as two years. . filing. and control. profit margins. an initial public offering provides a public valuation of a small business. printing costs. it is always possible that an unforeseen problem will derail the IPO before the sale of stock takes place. and mailing expenses. In his article for The Portable MBA in Finance and Accounting. The small business owner and other top managers must prepare registration statements for the SEC. flexibility. accounting. The dilution of ownership also reduces management's flexibility. . If enough shareholders become disgruntled with the company's stock value or future plans. Offering shares of stock and stock options as part of compensation may enable a small business to attract better management talent.

of course. For example. preferred dividends. Similarly. while the denominator accrues to all holders of capital. are influenced by leverage. the relevant denominator must be computed after interest. EV multiples are calculated using denominators relevant to all stakeholders (both stock and debt holders). an Equity Value/EBITDA multiple is meaningless because the numerator applies only to shareholders. since the denominator is computed higher up on the income statement3.Unfortunately. relevant to that business3. . equity value multiples are calculated using denominators relevant to equity holders. on the other hand. Public entities also encounter added costs associated with handling shareholder relations1. so long as the multiple is. EV multiples are typically less affected by accounting differences. that the value of a firm is theoretically independent of capital structure. but would be inappropriate for consulting firms. preferred dividends. Enterprise value multiples are better than equity value multiples because the former allow for direct comparison of different firms. VALUATION MULTIPLES Valuation multiples are the quickest way to value a company. only. Equity value multiples. Therefore. but the denominator accrues only to shareholders. The additional reporting requirements for public companies also add expense. One very important point to note about multiples is the connection between the numerator and denominator. Additionally. EBITDA) to yield an enterprise or equity value. Multiples are expressed as a ratio of capital investment to a financial metric attributable to providers of that capital3. The choice of multiple(s) in valuing and comparing companies depends on the nature of the business or the industry in which the business operates. and minority interest expense. EV/(EBITDA−CapEx) multiples are often used to value capital intensive businesses like cable companies. To figure out which multiples apply to a business you are considering. long-term strategic investment decisions may tend to have a lower priority than making current numbers look good. They attempt to capture many of a firm's operating and financial characteristics (e. highly levered firms generally have higher P/E multiples because their expected returns on equity are higher. Recall. we can invent virtually any multiple we like to value a business. With this understanding of the relationship between numerator and denominator. For example. as the small business will likely need to improve accounting systems and add staff. regardless of capital structure. On the other hand. Since enterprise value (EV) equals equity value plus net debt. and are useful in comparing similar companies (comparable company analysis).g.g. and minority interest expense3. the relevant denominator must be computed before interest expense. Therefore. expected growth) in a single number that can be multiplied by some financial metric (e. try looking at equity research reports of comparable companies to see what analysts are using3. For example. an EV/Net Income multiple is meaningless because the numerator applies to shareholders and creditors.

EV/Sales multiples are often in the range of 1. For example. reflect real expenses associated with the utilization and wear of a firm's assets that will ultimately need to be replaced. we would simply say "EBITDA multiple".00x.00x P/E is one of the most commonly used valuation metrics. making it .00x to 3. EV/EBITDA is often EBITDA in the range of 6. EPS figures may be either as- reported or adjusted as described below. when talking about the EV/EBITDA multiple. P/E/G The PEG ratio is simply the P/E ratio divided by the expected EPS growth rate. revenue is a poor metric by which to compare firms. EV/EBIT is often in the range of 10. Note that the P/E multiple equals the ratio of equity value to net Income. in which the numerator and denominator are both P/E are divided by the number of fully diluted shares.0x to 18. Unlike EBITDA.0x. as EBITDA is EV / commonly used as a proxy for cash flow available to the firm. as in the case of a non- capital-intensive company such as a consulting firm. PEG ratios are more flexible than other ratios in that they allow the expected level of growth to vary across companies. EBIT recognizes that depreciation and amortization. as might be the case with nascent Internet firms.0x. EBIT while non-cash charges. In such cases. However. we generally refer to some multiples using the denominator only. When depreciation and amortization expenses are small.0x to 30. P/E multiples are often in the range of 15.In practice. Multiple Comments EV/EBITDA is one of the most commonly used valuation metrics. EV/EBIT and EV/EBITDA will EV / be similar.0x to 25. and is often in the range of 0. where the numerator is the price of the stock and the denominator is EPS. because the numerator is implied. for example. When a company has negative EBITDA. EV/Sales may be the most appropriate multiple to use.0x. EV/Sales is commonly used in the valuation of companies whose operating costs EV / Sales still exceed revenues.50x to 3. the EV/EBITDA and EV/EBIT multiples will not be material. because the only sensible numerator is EV3. since two firms with identical revenues may have wildly different margins.

accounting changes. Historical valuation multiples are usually calculated over the last twelve month (LTM) period. Projections. There is no standard time frame for measuring expected EPS growth. and subtract the EBITDA from the corresponding stub period last year. We will focus our discussion here on flows3. book value). Also. the portion of EBITDA and EBIT attributable to the non-controlling interest should also be excluded from the denominator3. but it is necessary to verify that all such estimates use the same yearly basis (either calendar or fiscal) to make apples-to-apples comparisons3. legal settlements. Forward estimates can be obtained from sources like Bloomberg. These projections are usually provided on a calendar year basis for consistency. easier to make comparisons between companies in different stages of their life cycles. growth rate. firms3. Publicly traded U. discontinued operations. and IBES. Discounted Cash Flow (DCF) What is a 'Discounted Cash Flow (DCF)' A discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. for example. Most publicly traded companies are valued based on their projected. When using multiples to compare similar companies in a peer group as part of a comparable company’s analysis. or forward estimates. are made by equity research analyst estimates.g. First Call. but practitioners typically use a long-term. one-time gains/losses. whether historical or projected. etc. and often averaged for use in calculating valuation multiples. Adjust the denominator to exclude the effects of extraordinary and non-recurring items such as restructuring charges.g. and asset impairment charges.S. add the EBITDA from the most recent stub period to the latest full-year EBITDA.S. if non-controlling interest is excluded from the calculation of EV. EBITDA). A stock is measured at a single point in time (e. it is necessary to ensure that the comparison is "apples-to-apples". such as stock-based compensation3. Net Income. while a flow is measured over a period of time (e. To calculate the LTM EBITDA. companies report earnings on a quarterly basis. rather than historical. This means that the denominators of all multiples compared should span the same time period. it is possible that the LTM periods for some foreign firms will not chronologically align with the LTM periods for U. Calculating the Denominator (EBITDA. earnings and cash flows. Therefore.) The denominator may be either a stock or a flow. or 5-year. and be adjusted for the same items. DCF analysis uses future free cash flow projections and discounts them . but many publicly traded foreign firms only report earnings every 6 months on a semi-annual basis.

We would start by determining the company's trailing twelve month (ttm) free cash flow (FCF). adjusted for the time value of money4. It is also important to consider the source of this growth. Due to the symmetric property (if a=b. Are sales increasing? Are costs declining? These factors will inform assessments of the growth rate's sustainability4. it is common to use the weighted average cost of capital (WACC) as the discount rate4. For a hypothetical Company X. Say that you estimate that Company X's cash flow will grow by 10% in the first two years.05 in a year. Say that Company X's ttm FCF is $50 m.00 today. the purpose of DCF analysis is simply to estimate the money an investor would receive from an investment. we must consider $1. then b=a).00 in a savings account will be worth $1. The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow. But while the calculations involved are complex. After a few years. This value should probably not exceed the long-term growth prospects of the overall economy by too much. For example. $1. the opportunity may be a good one4. you may apply a long-term cash flow growth rate. which is used to evaluate the potential for investment.05 a year from now to be worth $1. is calculated using the Gordon Growth Model4: . You will then calculate a arrive at a present value estimate. representing an assumption of annual growth from that point on. we will say that Company X's is 3%. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. say it comes out to 8%. If the value arrived at through DCF analysis is higher than the current cost of the investment. assuming 5% annual interest. When it comes to assessing the future value of investments. equal to that period's operating cash flow minus capital expenditures. or long-term valuation the company's growth approaches. we would apply DCF analysis by first estimating the firm's future cash flow growth. BREAKING DOWN 'Discounted Cash Flow (DCF)' There are several variations when it comes to assigning values to cash flows and the discount rate in a DCF analysis. Calculated as: DCF is also known as the Discounted Cash Flows Model. The terminal value. then 5% in the following three.

05 63.442.085) = 1231.83 $1. If we divide that by the number of shares outstanding—say 10 m—we have a fair equity value per share of $123.08 .70 Year 5 = 66.04 Terminal value = 70. but they are only as good as their imports. and every assumption has the potential to erode the estimate's accuracy4.5 Year 3 = 60.10 55 Year 2 = 55 * 1. Small changes in inputs can result in large changes in the estimated value of a company.53 * 1.082) + (63. to calculate Company X's discounted cash flow.70 / 1. .081) + (60. garbage out".75 Finally. Discounted cash flow models are powerful.75 / 1. as equity holders' claims to a company's assets are subordinate to bondholders'. including the the terminal value4: Year 1 = 50 * 1. As the axiom goes.03) 1.04 / 1.083) + (66.05 66. If our estimate is higher than the current stock price.05 70.10 60.23 b is our estimate of Company X's present enterprise value. we might consider Company X a good investment4.085) + (1.0.04 (1.5 / 1.5 * 1.53 Year 4 = 63.084) + (70.70 * 1. this needs to be subtracted.Terminal value = projected cash flow for final year (1 + long-term growth rate) / (discount rate - long-term growth rate) 4 Now you can estimate the cash flow for each period. you add each of these projected cash flows.53 / 1. If the company has net debt.18.03) / (0. "garbage in.442. adjusting them for present value using the WACC4: DCFCompany X = (55 / 1. The result is an estimate of the company's fair equity value. which we can compare with the market price of the stock. Offerings.asp#ixzz40tC8OE00 .html#ixzz40t7UFr2p 2 .asp#ixzz40t85dHYi 3 .1 .com/terms/d/dcf.http://www.investopedia.https://macabacus. 4 .http://www.investopedia.