valuation for m a Building Value in private companies phần 10 potx

Exhibit 16-7 Normalized Net Income Years 1 through 5:Invested Capital Basis in thousands Year 1 Year 2 Year 3 Year 4 Year 5 Pretax Income to Invested Adjustments b Adjusted Pretax Incom

266

Exhibit 16-7 Normalized Net Income Years 1 through 5:

Invested Capital Basis (in thousands)

Year 1 Year 2 Year 3 Year 4 Year 5

Pretax Income to Invested

Adjustments b

Adjusted Pretax Income to

Invested Capitala(aka adjusted

Income Taxes: Federal and State, estimated at 40%d 3,200 Normalized Net Income Applicable to Invested Capital 4,800

debt and equity capital providers.

de-scribed in the narrative portion of the case.

operating performance as of the end of Year 5 Alternatively, the adjusted pretax come to invested capital of $7,650,000 in Year 5 could be increased by the anticipated long-term growth rate of 4%, which would have generated approximately the same amount.

em-ploys the invested capital model, which is predebt, it does not consider the tax deductibility

of interest expense An alternative is to reduce the income tax by 40% of interest expense.

Lou Bertin’s Compensation

Lou Bertin’s compensation package exceeds the market rate dinal’s human resources expert’s research indicated that the totalcost of market-rate compensation paid to an arm’s-length CEO of apublisher the size of Cardinal over the past five years would haveprovided the following savings, inclusive of payroll-related burdens:

Jeffrey Meier’s Compensation

This position is required for the company’s success, and the salary

is appropriate for a properly qualified VP of Marketing Thus, noadjustment is required

Market Research

In three of the past five years, Cardinal has spent between

$200,000 and $300,000 for market research to allow the company

to better understand its customer base While some would arguethat this is a nonrecurring expense that should be added back todetermine normalized income, it was concluded that these costsenable the company to offer the attractive products that make ituniquely appealing to its customers This adjustment is a judg-ment call and is considered to be a recurring cost because it isnecessary for the company to remain competitive in the longterm

Gain on Sale of Land

The company sold land in Year 4 for $1.8 million that generated again of $1.5 million Since this is not part of the company’s ongo-ing income, it is subtracted as a normalization adjustment

Other Assets

These assets include vacant land adjacent to the company and a cation home in St Maarten used by Bertin exclusively for personalpurposes These assets do not generate income or expenses, so noadjustment to the income statement is required Their marketvalue can be added to the operating value to yield Cardinal’s totalequity value

va-Risk and Value Drivers

The factors that should influence the development of the discountand capitalization rates appropriate to Cardinal’s stand-alone fairmarket value are described in the following sections Exhibits 16-8and 16-9 are used to develop the rates

Economic Conditions

Lower forecasted advertising expenditures are expected to hurt allmagazine companies in the next 12 months as economic condi-tions generally decline

Industry and Competitive Considerations

Industry sales are dominated by conglomerates, which possessstronger ties to advertisers and much stronger distribution systems.Independents face higher operating costs, such as paper costs andpostage rates, and are weaker technologically Numerous magazinesare launched yearly, with more than half failing within 12 months,and of the remaining, 95% will fail within five years of introduction

Financial Condition and Access to Capital

The company carries substantial debt and lacks capital for nology upgrades

tech-Management

Lou Bertin, who is approaching the typical retirement age, isthe only Cardinal employee capable of providing executive

Exhibit 16-8 Rates Applicable to Net Income to Equity (As of the

Appraisal Date)

Average Market Return Adjusted to

Specific Company Risk Premium:

 Industry Risk (larger, stronger competitors) 3.00

 Management Risk (thin management and

Rate of Return for Net Cash Flow to Equity d 25.00

Rate of Return for Net Income to Equity 28.00

Capitalization Rate for Net Income to Equity 24.00

in-c

Risk premium for size is to recognize the additional risk associated with a company the size of the tenth decile on the New York Stock Exchange.

d

This is a rate of return, or discount rate, directly applicable to net cash flow as it is based

on the return to investors, net of income tax to their corporations.

Long-term sustainable growth rate was provided in the assumptions to the case.

Note: The rate developed above is appropriate to the valuation assignment in this case This

exhibit is intended to demonstrate a process for the development of this rate, and the amounts shown are for illustration purposes only The rate appropriate to a given valuation must consider the risks, economic and industry factors, the effective date, the size of the in- terest being valued, and the intended use of the appraisal.

Exhibit 16-9 Weighted Average Cost of Capital (WACC) and

Capitalization Rate Applicable to Net IncomeAvailable to Invested Capital

Applicable Rates:

of 28.00% The computation of the equity cap rate of 24% is shown in Exhibit 16-8 but is not used in this computation The WACC cap rate is computed in Exhibit 16-9.

Ex-hibit 16-8 to the 28% rate for net income in that exEx-hibit.

is reduced by the tax subsidy provided by the deductibility of interest expense.

from the discount rate to convert it to a capitalization rate.

the return to equity and debt on an income basis This amount would be equal to the net income to equity if Cardinal were debt free Cardinal’s actual interest-bearing debt will then

be subtracted from invested capital value to yield equity value.

$19,442
$4,992 ($16,300 (.06  04))

(.28  04)

management Marketing management is lacking, and seniormanagement is generally thin.

Proprietary Customer Knowledge

Cardinal’s market research has revealed substantial information garding the tastes and spending habits of what appears to be a large,underserved segment of the North American population Whilelarger publishers are beginning to recognize the potential spendingpower of this customer base and wish to exploit it, Cardinal, as astand-alone business, lacks both the financial resources and mar-keting expertise to capitalize on this proprietary knowledge

re-Customer Base

Cardinal possesses a base of highly loyal customers who are tracted to the company’s high-quality photography, homespun im-age, and low subscription rates

at-Single-Period Capitalization Computation

of Stand-Alone Fair Market Value

Using the normalized net income to invested capital of

$4,992,000, computed in Exhibit 16-10, and the weighted averagecost of capital developed in Exhibit 16-9, the stand-alone fair mar-ket value of 100% of the equity of Cardinal on a control basis iscomputed to be $19,434,000, with invested capital totaling

$35,734,000 This computation uses the single-period tion method because Cardinal’s returns over Years 1 through 5have been sufficiently stable to derive a reliable estimate of thecompany’s performance by using a return for one period Use ofthis method is also supported by the choice of a long-term growthrate of 4%, which appears to be appropriate for Cardinal giveneconomic, industry, and company conditions

capitaliza-The invested capital model, which is usually employed in uations for merger and acquisition, is used with debt and equityweightings adjusted to market values rather than book values Netincome, rather than net cash flow, is chosen as the return todemonstrate its use, although net cash flow is generally preferred

val-The rates of return have been adjusted from net cash flow to netincome to prevent distortions that occur when rates and returnsare mismatched.

The invested capital value of $35,733,715 from Exhibit 16-10

is divided by the normalized EBIT and earnings before interest,taxes, depreciations, and amortization (EBITDA) amounts forYear 5 to yield the resulting implied multiples of EBIT andEBITDA shown in Exhibit 16-11

Guideline Public Company Computation of Stand-Alone Fair Market Value

Using three normalized returns to invested capital for Year 5 andoperating multiples, the guideline public company method devel-oped the stand-alone fair market value of 100% of the invested cap-ital and equity of Cardinal The guideline public company method

is used because the search identified a sufficient number of licly traded companies in the printing and publishing industry that

Capital Basis Converted to Equity

were adequately similar to Cardinal to determine value based onthe price paid for alternative investments in the public markets.

The guideline public company method employs the investedcapital model where returns to debt and equity include EBIT,EBITDA, and revenues These returns are compared to the mar-ket value of invested capital (MVIC), rather than the equity priceper share, because the returns are to debt and equity Based on re-search and analysis of the guideline companies, considering theirperformance and strategic strengths and weaknesses, along withindustry conditions and trends, they were compared to Cardinalbased on various operational performance measures The follow-ing ratios were computed for each of the guideline companies, in-cluding the mean and median for each ratio:

MVIC to EBITMVIC to EBITDAMVIC to Revenues

To begin the search for guideline companies we selected thefollowing criteria:

Public Guideline Companies

Industry SIC 2841: Printing and Publishing

Size Annual sales between $7.5 million and $750

million (within a factor of 10 times the size ofCardinal)

Time Transactions as of the valuation date

Type Minority interest transactions

of Adjusted EBIT/EBITDA (in thousands)

Implied Implied

Normalized EBITDA for

Status Profitable companies, financially solvent and

reasonably leveraged, that are freely and activelytraded

Growth Companies whose recent historical growth rates

and forecasted growth rates are reasonably similarDomicile U.S corporations

The guideline companies that were selected are:

Guideline Companies

Latest Latest Fiscal Name Fiscal Year Year Sales

CRP Publications 12/31/Year 5 144,496,402

Night Rider, Inc 9/30/Year 5 66,851,000

Industry Trends 6/30/Year 5 597,165,000

Hanover Media 3/31/Year 5 361,822,000

Leisure Living 12/31/Year 5 662,501,000

The following is a brief description of each company

• CRP Publications: a diversified media company that

produces nine journals that cover emerging technology

industries It also provides market research services

• Night Rider, Inc.: operates through three subsidiaries,

which publish special-interest magazines relating to the

motorcycle, trucking, and tattoo industries

• Industry Trends: publishes 21 industry-specific journals andnewsletters, which it markets through affiliations with

industry trade associations

• Hanover Media: publishes, produces, and distributes

Christian-oriented magazines, online services, and books,and markets a line of religious gift and stationery products

• Leisure Living: markets resorts and time-sharing resort

properties as well as three consumer magazines that coverthe travel and leisure industry

From available public sources, extensive information aboutthe five public guideline companies was gathered, including theirannual reports, U.S Security and Exchange Commission’s Forms

10-K, and information from various stock reporting services andindustry analysts’ reports The operating performance, financialposition, and cash flow of each company was analyzed Their com-petitive advantages and disadvantages were considered in light ofindustry and economic conditions From this data, the informa-tion in Exhibit 16-12, about the companies’ operating perform-ance, is summarized.

From the data in Exhibit 16-12, operating multiples that pare the market value of invested capital to EBIT, EBITDA, andrevenue per share are computed and presented in Exhibit 16-13,along with the resulting mean and median multiples of each op-erating measure These multiples reflect investor consensus of thevalue of these five companies in this industry and present a basisfor selection of appropriate multiples for Cardinal based on thesealternative investment choices

Per Share

Exhibit 16-14 Comparison of Cardinal With Guideline

Companies

Comparison to the Guideline

Cardinal’s current ratio and quick ratio are

both just above the industry average shown

in Exhibit 16-6 Cardinal’s cash position has

declined while its current liabilities have

increased in the last year.

Cardinal’s total assets, accounts receivable,

inventory, and fixed assets are all carried at

substantially higher levels relative to the

company’s sales than any of the guideline

public companies This reflects substantial

inefficiency in the utilization of all of these

assets and sharply reduces the cash flow to

capital providers.

Cardinal’s debt, though decreasing steadily

over the last five years as a percentage of

total assets, is higher than four of the five

guideline companies.

Cardinal’s stronger profit margins

compensate somewhat for the company’s

weaker asset utilization to generate profits

similar to the guideline companies.

Cardinal’s 15% annual compound growth

rate over the last five years is less than three

of the five guideline companies, but its

projected long-term growth is similar to that

of the guideline companies and the industry.

Based on this comparison of Cardinal with the guideline publiccompanies, the following value multiples shown in Exhibit 16-15 wereselected as appropriate for Cardinal when compared to the guide-line companies considering Cardinal’s performance and risk profile.

Estimate of Equity Value of Guideline Company Method

The market value of the company’s long-term debt is subtracted inExhibit 16-16 from the previously determined value of investedcapital, to obtain an equity value, which for the market approach

Based on the Guideline Company Approach

Normalized Operating Value Estimated Invested Procedure Results for Year 5  Multiple
Capital Value

the Guideline Company Approach

Estimated Invested Market Value of Estimated Procedure Capital Value  Long-Term Debt
Equity Value

newspapers and electronic reporting services located in the western United States Western was traded on the NASDAQ stockexchange, and, in that transaction, Granite paid a 72% premiumover Western’s preacquisition stock price This transaction, whichwas paid for in Granite’s stock, reflected a multiple of nine timesWestern’s forecasted EBITDA Over the last 10 years, Granite hasmade numerous such acquisitions of local and regional newspaperchains, which is part of a long-term trend of consolidation in thenewspaper industry Further analysis of this transaction and othersmade by Granite led to the conclusion that the price paid and theresulting multiples from this transaction reflect synergies unique

south-to Granite and do not provide a reliable basis for determination ofCardinal’s value In general, it is inappropriate to attempt to es-tablish “the market” based on the results of a single transaction

Rejection of the Adjusted Book Value Method

To consider the fair market value on a stand-alone basis of nal from the perspective of the value of the assets owned by thecompany, an adjusted book value computation could be per-formed This method, which assumes value is derived from a hy-pothetical sale of the specific tangible and intangible assets of thecompany, does not specifically recognize general intangible valuethat may exist as a result of the company’s technology, customerbase, reputation, and other general goodwill factors While gen-eral goodwill value can be computed through a computation

Cardi-known as the excess earnings method, this is generally not done in

val-uations for merger and acquisition This is a method that is plied usually only in the valuation of very small businesses, such asprofessional practices, so it will not be used to appraise Cardinal

ap-Summary and Conclusion of Stand-Alone Fair Market Value

The results of the valuation procedures employed to computethe fair market value of Cardinal’s equity are summarized in Ex-hibit 16-17 After employing the various reconciliation method-ologies explained in Chapter 13, the fair market value of equity

is determined to be $20.1 million, including Cardinal’s erating assets

nonop-280

COMPUTATION OF INVESTMENT VALUE

This computation of investment value will use the multiple-perioddiscounting method and will recognize the synergies that can beachieved through this acquisition

Risk and Value Drivers

To develop the discount rate for equity and the weighted averagecost of capital (WACC) to be used by Omni in its evaluation ofCardinal, adjustments, shown in Exhibit 16-18, have to be made

to the rates developed previously in Exhibits 16-8 and 16-9 forCardinal Omni is a midcap-size publicly traded company, so thesize adjustment for Omni is substantially less than for Cardinal

In addition, most of the specific company risk factors for nal can be eliminated when it operates as a division of Omni Indeveloping the specific company risk premium for Omni, the ad-ditional risk created by the presence of competitors much largerthan Cardinal is eliminated by Omni’s size and market strength.However, because Omni does not possess substantial expertise orexperience in the rural market served by Cardinal, it imposed a1% risk premium to reflect its movement into a less certain mar-ket Omni’s financial strength eliminates the financial and man-agement risk factors that exist with Cardinal as a stand-alonebusiness

Cardi-While some doubt exists as to whether Cardinal’s strong tomer loyalty can be maintained when the company operates as adivision of a conglomerate, Omni management is attracted to thevery high untapped sales potential of this customer base WhileCardinal lacks the expertise and resources to take advantage ofthis sales potential, Omni sees this as a substantial synergistic ad-vantage that reduces the riskiness of this acquisition

cus-The discount rate to equity of 14.5% from Exhibit 16-18 iscombined with Omni’s cost of debt at the prime rate of 9%, based

on the market value of Omni’s debt and equity shown in Exhibit16-19 to yield the WACC discount rate of 12.23% and the WACCcap rate of 8.23%

It should be obvious from a comparison of Omni’s WACC count of 12.23% in Exhibit 16-19 versus Cardinal’s of 17.97% from