Market size linked to profitability

Growth rate in revenues (or sales) gr is: gr = (%average mkt share) x (growth rate in mkt segment) Hence a firm can only increase sales growth if: (1) % mkt share increase or (2) Growth rate in mkt segment increases Example: 50% x 10% = 5% Alternatively this means that the firm growth rate, gr, is limited by these variables. If a firm has new technology and even if its mkt share is 100%, if growth rate of mkt segment is only 10%, the firm’s gr = 10%. Generally growth in mkt segment is fixed, so a firm can only increase gr by increasing its mkt share by taking competitors’ market share. Finally the growth rate in net profits (net profit margin) gr impacts ge. ge = (net profit margin) x (gr) Note that there may be a trade-off between the net profit margin and % mkt share. For example, if a firm decreases labor expense to cut costs to increase net profit margin, it could reduce %mkt share. However, if a firm is expected to compete, they must increase mkt share at the same time that the firm increases net profit margin in order to increase ge.

Valuation Methods
There are at least 3 different methods to value common equity of a firm. 1. 2. Discounted Cash Flow (DCF) Valuation: PV of future free cash flow of the firm PLUS a PV of a terminal value based on assumptions about future sustainable constant growth rate. Comparable Firms Valuation: Taking ratios of comparable firms and applying it to the IPO firm. Ratios often used are P/E, market-to-book, price-to-sales, and Price/EBIT.

3. Real Options: Using a modified version of Black Scholes Option Pricing Model to value the common equity as a call option to the future investment opportunities of the firm. We will use the first 2 methods to value IPOs. DCF Approach to Valuation: Value of a firm equals the PV of future Free Cash Flows PLUS the PV of the terminal value growth at a constant sustainable growth rate, gs.

t =1


FCFt FCFT (1 + g s ) + t (1 + k w ) (k w - g s )(1 + k w ) T

Where: FCF = Free Cash Flow defined as: FCF = (1-tax rate)(EBIT) + Depreciation-Capital Expenditures+/-changes in NWC And kw is the weighted average cost of capital (WACC). DCF Approach has 2 parts to evaluate its firm value. Part I estimates the cash flows and Part II requires an estimation of WACC or kw. PART I. See the tables on the next page to determine the cash flows for F&C International. It requires many forecasts by the analysts and the numbers are usually difficult to assess for new firms. See TABLE 1 and TABLE 2. PART II. The WACC must be estimated for F&C International. The usual method for estimating the discount rate is to use the Capital Asset Pricing Model (CAPM). Before using the CAPM, the following procedure is taken to estimate beta. (1) Unlevered beta is estimated using Hamada’s equation using publicly traded firms similar to F&C. Using Exhibit 5, there are 4 comparable firms with levered beta. This indicates that the beta includes the financial risk associated with the amount of debt held by these firms. Hence, the unlevered beta, βA, is estimated by plugging in each firm’s βE or levered beta. The average for the 4 firms is an unlevered beta, βA equaled to 1.00. (This is a coincidence to equal the market beta). (2) Next F&C’s levered beta, βE can be calculated using F&C’s capital structure after the IPO and Hamada’s general equation assuming βD=0:

Debt ( β A − β D )(1 − taxrate) Equity Assume debt is riskfree then β D = 0 then

βE = βA +
⎡ ⎣

β E = β A ⎢1 +

⎤ Debt (1 − taxrate)⎥ Equity ⎦

TABLE 1. Forecasts of variables used in DCF valuation. Year 1992 1993 1994 Growth rate of revenues (%) Pre-tax operating margin (%) or EBIT/revenues Working capital/revenues (%) Net capital expenditures/revenues (%) Corporate tax rate (%)



1997 & beyond

15% 2% 35%

15 2 35

15 2 35

15 2 35

15 2 35

15 2 35

TABLE 2. Cash flow forecasts for F&C International Net FCF (in millions) = (1-tax rate)EBIT – Net capital expenditure – Change in NWC YEAR (1-tax rate)EBIT ─Net Capital Expenditure (with added depreciation) +/-change in Net Working Capital (NWC) =Free Cash Flow (FCF) PV factor @kw rate

1992 1993 1994 1995 1996 Terminal value* *Terminal value =

FCFT (1 + g s ) (k w - g s )

VFIRM = VEQUITY + VDEBT therefore VEQUITY = VFIRM – VDEBT For F&C we have: VEQUITY = $ M - $6 M = $

F&C wants to raise net proceed in the amount of $21M and their issuance ocst is expected to be 12 to 13% (rounded to 12.5%). This means that the TOTAL PROCEED (TP) that must be raised including issuance cost is: (1 - .125)TP = $21M which means TP = $24M.

What is IPO PRICE?

Comparable Firms Valuation Approach. By examining several firms of comparable line of businesses and capital structure, determine various ratios.
Price/earnings = P/E Price/sales MV of Equity/EBIT MV of equity/BV of equity Using ratios from Comparable Firms in Exhibits 3, 4, 5, and 6 we can calculate: F&C Total Equity Value = AVE of 4 comparable firms’ MV of equity/BV of equity x F&C BV of equity F&C Total Equity value = AVERAGE of 4 comparable firms’ P/E x F&C 1992 earnings F&C Total Equity Value = AVE of 4 comparable firms’ Price/sales x F&C 1992 Sales F&C Total Equity Value = AVE of 4 comparable firms’ MV of equity/EBIT x F&C 1992 EBIT RATIOS Mkt Value/Book Price/Earnings Price/Sales Price/EBIT Range Average Total Equity Value Price/share range** IPO price/share **IPO price/share = (Total Equity Value - $24M)/(4.98M - .457M shares) NOTES: 1992 EBIT = .11(1992 revenues) = .11 x ($70.385) = $7.7M Earnings = (EBIT – Int Expense)(1-tax rate) = ($7.7M-(.08)($6M))(1-.35) = $4.7M Assuming interest rate on debt is 8%. NOW CHOOSE ONE comparable firm in Exhibits 3, 4, 5, & 6 that is MOST similar to F&C. STATE reasons for the chosen firm. Define the criteria used to determine the “Most similar firm to F&C”. RATIOS Ratio estimates Average Total Equity Value Price/share range** IPO price/share Mkt Value/Book Price/Earnings Price/Sales Price/EBIT

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