Professional Documents
Culture Documents
of Finance
Valuation case
Erwan Morellec
Ideko Valuation
□ Consider Ideko Corporation, a privately held firm. The owner has
decided to sell the business
□ Your job is to evaluate purchasing the company, implementing
operational and financial improvements, and selling the business at
the end of five years
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Ideko Valuation
□ Income statement and balance sheet
Ideko Valuation
□ A price of $150 million for Ideko’s equity has been suggested, which is
almost double Ideko’s current book value of equity
□ Industry multiples
□ What range of acquisition prices for Ideko is implied by the range of
multiples for P/E, EV/Sales, EV/EBITDA?
2
Ideko Valuation
□ For each multiple, we can find the highest and lowest values across all
firms and the industry portfolio. This yields the following results
Range Price (in $ million)
Multiple Low High Low High
P/E 18.2 28.0 126.3 194.3
EV/Sales 1.4 2.7 107.0 204.5
EV/EBITDA 9.3 14.4 153.1 236
For example, Nike has the lowest P/E multiple of 18.2. Multiplying this P/E
by Ideko’s earnings of $6.94 million gives a value of $126.3 million.
The highest multiple of entreprise value is 2.7: At this multiple, Ideko’s
entreprise value is 2.7x75=$202.5 million. Adding Ideko’s excess cash and
subtracting debt implies a purchase price of 202.5+6.5‐4.5= $204.5 million
Ideko Valuation
□ To assess whether this investment is attractive, the operational
aspects of the firm and of the ultimate cash flows that the deal is
expected to generate need to be analyzed
□ On the operational side, you are quite optimistic regarding the
company’s prospects
‣ Market size is forecast to increase at a 5% rate
‣ Ideko produces a superior product. However, market share has
not grown in recent year because management has devoted
insufficient resources to product development, sales and
marketing
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Ideko Valuation
□ 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 five
years
‣ The increased sales demand can be met in the short run using
the existing production lines. Once the growth in volume exceeds
50%, Ideko will need to undertake a major expansion to increase
its manufacturing capacity
‣ Ideko’s average selling price is forecast to increase 2% each year.
Raw materials are forecast to increase at a 1% rate. Labor costs
are forecast to increase at a 4% rate.
Ideko Valuation
□ Sales and operating costs assumptions
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Ideko Valuation
□ Based on the data in the above table, what production capacity will
Ideko require each year? When will an expansion be necessary?
Ideko Valuation
□ Production volume each year can be estimated by multiplying the
total market size and Ideko’s market share
Based on this forecast, production volume will exceed its current level
by 50% by 2008, necessitating an expansion then
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Ideko Valuation
□ In 2008, a major expansion will be necessary for Ideko, leading to a
large increase in capital expenditures in 2008 and 2009
□ What about working capital requirements?
Ideko Valuation
□ Ideko’s Accounts Receivable Days is
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐. $
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐. 𝐷𝑎𝑦𝑠 365𝑑𝑎𝑦𝑠/𝑦𝑟
𝑆𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 $/𝑦𝑟
or
18493
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐. 𝐷𝑎𝑦𝑠 365 90𝑑𝑎𝑦𝑠
75000
□ The industry average is 60 days
□ You believe that Ideko can tighten its credit policy to achieve the
industry average without sacrificing sales
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Ideko Valuation
□ 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
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑎𝑦𝑠 365 45,6𝑑𝑎𝑦𝑠
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□ You believe that, with tighter controls of the production process, 30
days worth of inventory will be adequate
Ideko Valuation
□ You believe Ideko is significantly underleveraged so you plan to
increase the firm’s debt. The debt will have an interest rate of 6.8%, and
Ideko will only pay interest during the next five years
□ The firm will seek additional financing in 2008 and 2009 associated
with the expansion
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Ideko Valuation
□ In addition to the $150 million purchase price for Ideko’s equity, $4.5
million will be used to repay Ideko’s existing debt
□ With $5 million in transaction fees, the acquisition will require $159.5
million in total funds
□ KKP’s sources of funds include the new loan of $100 million as well as
Ideko’s own excess cash. Thus KKP’s required equity contribution to the
transaction is $53 million
Ideko Valuation
□ To build the pro forma income statement, begin with Ideko’s sales.
Each year, sales can be calculated as follows
□ The raw materials cost can be calculated from sales as follows
𝑅𝑎𝑤 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 𝑀𝑘𝑡 𝑆𝑖𝑧𝑒 𝑀𝑘𝑡 𝑆ℎ𝑎𝑟𝑒 𝑅𝑎𝑤 𝑀𝑎𝑡. 𝑝𝑒𝑟 𝑈𝑛𝑖𝑡
□ Sales, marketing, and administrative costs can be computed directly
as a percentage of sales
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Ideko Valuation
Calculations for 2006:
Sales = 10.5 mill x 11% x 76.50 = $88.358
Raw materials = 10.5 mill x 11% x 16.16 = $18.665
Direct labor costs = 10.5 mill x 11% x 18.72 = $21.622
Sales and marketing = 16.5% x Sales = 16.5% x 88,358 = $14.579
Administrative = 15% x Sales = 15% x 88.358 = $13.254
Income tax = 35% x Pretax Income = 35% x 7.988 = $2.796
Ideko Valuation
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Ideko Valuation
□ 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
□ The minimum cash balance: Minimum level of cash needed to keep
the business running. Firms earn little or no interest on these balances.
The opportunity cost of holding cash is accounted for by including the
minimal cash balance as part of the firm’s working capital
Ideko Valuation
□ Accounts Receivable requirements in 2006 are
□ Raw Materials requirements in 2006 are
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Ideko Valuation
□ Working capital requirements
Ideko Valuation
□ Using the data from the previous tables, Ideko’s free cash flows over
the next five years can be forecasted
□ The after‐tax interest expense can be calculated as follows
□ Net borrowing is calculated as
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Ideko Valuation
□ Free cash flows
Ideko Valuation
□ The information calculated so far can be used to project Ideko’s
balance sheet
□ On the balance sheet:
‣ Current assets and liabilities come from the net working capital
spreadsheet
‣ Inventory figures includes both raw materials and finished goods
‣ Property, plant, and equipment figures come from the capital
expenditure spreadsheet
‣ Goodwill is calculated as acquisition price minus existing book
value of equity
‣ Debt figures come from the planned debt and interest payments
spreadsheet
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Ideko Valuation
Ideko Valuation
□ We use the CAPM to compute the appropriate discount rate
□ The standard procedure for estimating betas is to regress excess
stock returns (Ri ‐ rf) against the market risk premium
□ Because Ideko is not publicly traded, comparable firms must be
used to estimate the firm’s beta
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Ideko Valuation
□ The top‐down beta for a firm comes from a regression (do not forget
to adjust for the firm’s financing policy)
□ The bottom‐up beta can be estimated by doing the following
‣ Find out the business that a firm operates in
‣ Find the unlevered betas of other firms in these businesses
‣ Take a weighted average of these unlevered betas
‣ Lever up using the firm’s debt equity ratio
□ To do so, we will assume these firms have a target leverage ratio so
that we can use the equation
𝐸 𝐷
𝛽 𝛽 𝛽
𝐸 𝐷 𝐸 𝐷
Ideko Valuation
□ Combining estimates of asset betas for multiple firms in the same
industry reduces the estimation error of the beta for the project
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Ideko Valuation
□ Unlevering betas assuming a target leverage gives
Firm 𝑬 𝑫 𝛽 𝛽 𝛽
𝑬 𝑫 𝑬 𝑫
Oakley 1,00 0,00 1,25 ‐‐ 1,25
Nike 0,83 0,17 1,40 0 1,16
Luxottica 1,05 ‐0,05 1,13 0 1,19
□ You decide to use 1.20 for Ideko’s unlevered beta
□ Your estimate of Ideko’s unlevered cost of capital is
𝑅 𝑅 𝛽 𝐸𝑅 𝑅 4% 1,2 5% 10%
Ideko Valuation
□ Practitioners often estimate a firm’s continuation value (or 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
15
Ideko Valuation
□ The continuation value is 1.8 times Ideko’s 2010 sales, and the
equity value is 16.3 times Ideko’s 2010 earnings
‣ These ratios are lower than the peer ratios estimated earlier
□ 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
□ An alternative to determine the continuation value is to use the
WACC valuation method
𝐹𝐶𝐹
𝑉
𝑟 𝑔
Ideko Valuation
□ If 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
□ If capital expenditures are defined as
□ Then Free Cash Flows, given 𝑔, can be estimated as
𝐹𝐶𝐹
1 𝑔 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑔 𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑔 𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
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Ideko Valuation
□ Problem: Estimate Ideko’s continuation value in 2010 assuming a
future expected growth rate of 5%, a future debt‐to‐value ratio of 40%
and a debt cost of capital of 6,8%
In 2010, Ideko unlevered net income is forecasted to be $15.849
million with working capital of $40.425 million. It has fixed assets of
$69.392 million. From the above equation, we can estimate Ideko’s
free cash flow in 2011 as
Ideko Valuation
□ With a debt‐to‐value ratio of 40%, Ideko’s WACC can be calculated
as
Given Ideko’s free cash flow and WACC, we can estimate Ideko’s
continuation value in 2010 as
11.151
𝑉 $275.33 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
9.05% 5%
This continuation value represents a terminal EBITDA multiple of
275.33/32.09=8.6
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Ideko Valuation
□ Combining both approaches
*Net investment equals the difference between capital expenditures and depreciation, so subtracting this
amount is equivalent to adding back depreciation and subtracting capital expenditures
□ The EBITDA multiple of 9.1 can be justified according the DCF method
with a nominal long‐term growth rate of about 5.34% (or a real growth
rate of 3,34% if the inflation rate is 2%)
Ideko Valuation
□ The estimate of Ideko’s continuation value can be combined with
the forecasts for free cash flow through 2010 to estimate Ideko’s value
today using the APV valuation model
□ The first step is to compute Ideko’s unlevered value
𝐹𝐶𝐹 𝑉
𝑉
1 𝑅
□ Next, the interest tax shield needs to be computed
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Ideko Valuation
□ Using the APV valuation model, the estimate for Ideko’s initial
enterprise value is $213 million, with an equity value of $113 million
□ Given that KKP’s initial cost to acquire Ideko’s equity is $53 million,
the deal looks attractive with an NPV of $60 million
Ideko Valuation
□ At this point, it is wise to step back and assess whether the valuation
results make sense
‣ Does an initial entreprise value of $213 million for Ideko seem
reasonable compared to the values of other firms in the industry?
‣ The multiples are now at the top end or somewhat above the
range of the values of the other firms used for comparison
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Ideko Valuation
□ Each 1.0 increase in the EBITDA multiple represents about $20
million in initial value. The buyer will break even on its $53 million
investment in Ideko with an exit multiple of slightly more than 6.0.
□ An exit multiple of 6.0 is consistent with a future growth rate for
Ideko of less than 2%, which is even less than the expected rate of
inflation and probably unrealistically low
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