Solution to Case 12

Valuation of Common Stock

What Are We Really Worth?

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 Short family
regarding the issuance of an IPO? Explain why.

Disadvantages of going public

1) Loss of control
2) Transparency of information
3) Public scrutiny

Public scrutiny
1) Ability to raise funds and grow extensively
2) Fair value for stock and firm
3) Public capital market tends to be efficient in terms of cost of funds

Dan's concerns are well founded. The decision to go public really depends on how much
growth the firm expects to have and how much control it is willing to give up. There is a
limit to the amount of capital that can be raised privately, but it could be sufficient to support
the firm's growth expectations and need for external capital.

2. Comment on Lisa’s preference of the Corporate Value Model. Based on her

approach, what would Citrus Glow’s selling price per share be if they were to issue
5 million shares?

The Corporate Value Model is a useful way of valuing companies that are privately owned
because it relies on the discounting of future cash flows at an appropriate discount rate to
measure the overall value of a firm. Most of the other methods require comparative data on
price, beta, dividends per share, and earnings per share of similar publicly traded firms for
estimates of inputs to be used in applying the respective models.

Calculation of Citrus Glow's stock price based on the Corporate Value Model

1. Find PV of firm’s future FCFs

2. Find the market value (MV) of the firm.
3. Subtract MV of firm’s debt and preferred stock to get MV of common stock.

MV of stock = MV of Firm - MV of debt and preferred stock (if any)

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 Divide MV of common stock by the number of shares outstanding to get intrinsic stock price
(value).

Po = MV of common stock / # of shares

This is also called the free cash flow method. Suggests the value of the entire firm equals
the present value of the firm’s free cash flows. Remember, free cash flow is the firm’s after-
tax operating income less the net capital investment where net capital investment is equal to
the change in net fixed assets + the change in net working capital (edited by Prof. Mateev).

FCF = NOPAT – Net capital investment

EBIT 95,296,875
Tax Rate 40%
NOPAT 57,178,125
Change in Fixed assets 26,604,850
Free Cash Flow (2004) 83,782,975 *30,573,275
Expected growth rate of free cash flows =
year 1 20%
year 2 10%
year 3 onwards constant at 6%
Required rate of return on equity (based on CAPM Model)
Risk-fee rate (T-Bill rate) 4%
Market Risk Premium 8%
Beta (Average of 3 competitors' betas) 1.22
Required rate of return on equity 13.73%
Cost of Debt 14%
After-tax cost of debt 0.084
Weights Amount Weight
Debt 53,375,000 0.359730413
Equity 95,000,000 0.640269587
Total Capital 148,375,000
WACC 11.81%
PV
FCF in 2005 100,539,570 (20% increase)
FCF in 2006 110,593,527 (10% increase)
FCF in 2007 117,229,138 (11.87% - 6%)
Horizon value in 2006 2,016,057,657 2,126,651,184
Firm Value in 2004 $1,790,891,074
Debt 53,375,000
Equity Value $1,737,516,074
Number of shares 30,000,000
57.9172 Price

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 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 year 1-year ahead With 30
Company Company Company Average Current Level Compound Projected End of year Estimated million shares,
A B C Multiples 2004 Growth Level Estimated Value Value Today Price per share
Price/Earnings 23.6 24.6 22.8 23.7 52,374,375 Net Income 49.77% 78,440,452 =1,856,424,030 1,632,260,285 54.41

Price/Book 7.7 12.1 4.2 8.0 95,000,000 Book Value 39.62% 132,638,470 =1,061,107,762 932,978,689 31.10
of Equity
Price/Sales 2.9 2.8 2.9 2.9 500,000,000 Sales 49.27% 746,371,655 =2,139,598,744 1,881,241,569 62.71

Price/Cash Flow 13 16.7 14.7 14.8 62,077,500 Cash Flow 46.51% 90,952,754 =1,346,100,760 1,183,558,699 39.45

Note: N = 1, k Average
                    = 13.73% $46.92

Beta 1.22 
Risk-free rate 4% 
Market Risk Premium 8%
Required Rate (CAPM)= 13.73% 
   
Number of shares to be issued 30,000,000 
Estimated Price Per share 46.92
Total Value of Equity 1,407,509,810.22  
Dan's estimate under the Price Per share ratio approach turns out to be between $31 and $63 with an average of $47 as compared with Lisa's estimate of
$57.91. Under Dan's approach the firm's value is determined in relationship with the relative valuation ratios of the firm's top 3 competitors. So it would
give a more realistic value. Also, only 1-year ahead growth estimates have to be made reducing forecasting error. However, beta and required return
estimates are still required. 
 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 $1.50 per share at the end of the first year.

Period Growth Dividend during non- Price at end of non-

    rate constant growth phase constant growth phase
  1 30% 1.95
  2 30% 2.54
  3 30% 3.30
  4 20% 3.95
  5 20% 4.75
  6 6% $ 65.05
 
 
Dividend in Year 0 Do = $1.50
 
Required Rate 13.73%
 
Intrinsic Value $44.95

Joe's estimate of $44.95 is the lowest of the 3. However it is much closer to Dan's
estimate of $46.59 than Lisa's estimate of $57.91. 

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

                   
  Lisa's estimate $57.91 based on Corporate Value Model ???  
  Dan's Estimate $46.92 based on Price Per share ratio models  
  Joe's estimate $44.95 based on Dividend Discount Model  
   
  Average 49.92889  
   
Since the estimated values are based on fairly conservative expectations a simple average would
be fine. So an offer price of around $50 per share would be reasonable. This price is similar to
the competitors' current prices.