BusOrg (Fall 2013)
Valuation Hypos – Part 3
[RA - Michael Klotz <klotzmm@wfu.edu>]
Using the financials for Widget, Inc. at pp 202-03 of the casebook, prepare a spreadsheet
(with 9 worksheets) that answers the following questions:
1. Asset method: Let’s start looking at the balance sheet. What is the book value of
Widget, Inc.? Any reasons to doubt book value in valuing the company?
A.
As of Year 2, the book value was $1,120,000; this is historical and more
accurate
B.
As of Year 2, the book value was $1,460,000; this does not include
intangible assets (as required by GAAP)
C.
As of Year 2, the book value was $1,510,000; the market value of assets
(including intangible assets) is likely different from balance sheet items
D.
Not sure
2. Asset method: Let’s adjust the balance sheet, so it reflects market conditions. What is
the adjusted book value of Widget, Inc? Assume that only half of accts receivable will be
paid and only half of inventory will be sold, that the land has a FMV of $1.2 million, and
that goodwill is worth $1.4 million. Assume also that depreciation reflects actual loss in
value of building, machinery and other equipment. Any reasons to question adjusted
book value in valuing the company?
A.
The adjusted book value is $1,990,000 – mostly because adding goodwill,
which is questionable given that there is no market basis
B.
The adjusted book value is $165,000 – you cannot revalue land or include
goodwill under GAAP
C.
The adjusted book value is $1,120,000 – a more realistic value is the prior
year before so many things changed for the business
D.
Not sure
3. Market method: Maybe others have valued the business and we can “borrow” their
work? If there have been any transactions in the company’s shares, we can extrapolate to
figure out a 100% interest (enterprise value) for Widget, Inc., which has 500,000 shares
outstanding. Assume that there is a thin market in Widget, Inc. stock – with prices
ranging between $2.00-2.50 per share. Assume further that similar minority shares in
similar companies trade at a discount of 60% of fair market value, reflecting discounts for
these shares’ lack of liquidity and lack of control.
A.
The “enterprise value” of Widget is between $1.0 million and $1.2
million; all shares (minority or control) are worth the same
B.
The “enterprise value” of Widget is between $1.5 million and $1.8
million; liquid control shares fetch 50% more than illiquid minority shares
C.
The “enterprise value” of Widget is between $1.7 million and $2.1
million; illiquid, minority shares are worth less than liquid, control shares
D.
Not sure
4. Earnings method (comparables): Or maybe similar companies as Widget, Inc. have
been bought and sold. And we can use assumptions in those transactions to calculate
Widget’s value. Let’s value Widget, Inc. using the P/E ratio of other comparable
companies. (That is, if we know the price a company sold for and what it’s earnings
were, we can arrive at a “price/earnings” ratio.) Assume Widget, Inc is similar to a
basket of companies that recently have sold at 6.3 times earnings (on average). Any
reasons to question a P/E analysis?
A.
Any price/earnings analysis should consider earnings over period of time,
such as FY0 to FY2; price based on P/E is about $1.8 million
B.
Comparables are questionable: company similar? Earnings similar?
Earnings likely to continue? Based on FY2, price is about $2.5 million
C.
Only publicly traded securities are capable of a price/earnings analysis,
not a closely-owned Widget whose shares are not publicly traded
D.
Not sure
5. Earnings method (comparables): Perhaps we could just assume that earnings (after
some adjustments) will continue indefinitely and apply a discount rate to this perpetuity.
What should Widget, Inc. sell for using a discount rate based on current earnings, but
now adjusted to reflect that employee bonuses were de facto dividends? Assume Widget,
Inc is similar to companies whose value is calculated with a discount rate of 23%
of current earnings. What is the capitalization rate if the discount rate is 23%? Any
reasons to question a earnings capitalization analysis?
A.
Value based on FY2 adjusted net income is $2.2 million; cap rate assumes
lots (maybe too much) about company, its risk and prospects
B.
Value based on FY2 adjusted net income of $1.7 million; cap rate is
standardized depending on industry
C.
Value based on FY2 net income is $1.7 million; bonuses were tax
deductible and thus cannot be treated as owner dividends
D.
Not sure
6. Earnings method (DCF): The last calculation was a thinly-disguised “discounted cash
flow” analysis. So let’s look at what Widget, Inc. should sell for by discounting expected
future cash flows. Assume the company had net income of $390,000 last year, and
its plant, machinery and equipment are all in great condition (no need to depreciate). In
addition, the company paid $120,000 in bonuses to its owners that were de facto
dividends. “Normalize” these earnings. What are normalized earnings?
A.
Normalized earnings are often part of a DCF analysis, to approximate cash
flow: here normalized earnings are $510,000
B.
Normalized earnings are often part of a DCF analysis, adding back certain
non-cash accounting items: here normalized earnings are $760,000
C.
Normalized earnings are often part of a DCF analysis, subtracting certain
non-cash accounting items: here normalized earnings are $270,000
D.
Not sure
7. DCF continued: Let’s be more precise with our DCF analysis. Assume the normalized
earnings you calculated in #6 are discounted by 30% (to reflect bad accts receivable,
inventories, falling R&D in the business, state of machinery, etc), and further assume
these cash flows continue indefinitely. What is Widget, Inc.’s value assuming a
discount rate of 24% on these adjusted cash flows? What are the important assumptions?
A.
$3.0 million; discounting for “doubts about the business” violates GAAP,
and discount rate is a wild guess
B.
$2.2 million; discounting based on these “doubts about the business” is
guesswork, and discount rates are also an informed guesses
C.
$1.5 million; discounting for bad accounts/unsellable inventory should be
at least 50%, given results of last year, and discount rate comes from table
D.
Not sure
8. DCF continued. Let’s be a bit more precise, still. Assume that Widget, Inc.’s adjusted
cash flows (calculated in #7) will increase at 7.5% per year (inflation and company
growth), but there is greater uncertainty about this growth so the discount rate is now
35%. What is Widget, Inc’s value?
A.
The same as before, $2.2 million
B.
A bit less, about $2.1 million
C.
A good deal more, close to $3.0 million
D.
Not sure
9. DCF classic model. Let’s make some precise assumptions about cash flows the next
five years: $550,000 in Year 1, $580,000 in Year 2, $600,000 in Year 3, $530,000 in
Year 4 (some big equipment purchases), and $620,000 in Year 5, with cash flows of
$700,000 per year afterwards. Assume a discount rate of 30%. What is Widget, Inc’s
value?
A.
Just over $2.0 million – isn’t it amazing how things seem to be pointing to
one number! (Why is that?)
B.
The sum of first five years, and the first term in the infinite series divided
by two: $3,230,000
C.
It’s an infinite number, because $700,000 indefinitely is infinite!
D.
Not sure