Week 8 Notes:

Welcome to week 8! These are some concepts that will help you as you read through Case 45: JetBlue
Airlines IPO Valuation (pages 617-634) and with your assignment, Case 50: Flinder Valves and Controls
(pages 715-726). Please read through the notes below before reading the case, then read through the case,
then go through the case 45 notes.

INITIAL PUBLIC OFFERINGS

An initial public offering (IPO) is the process through which a privately held company issues
shares of stock to the public for the first time. Also known as "going public," an IPO transforms a
small business from a privately owned and operated entity into one that is owned by public
stockholders. An IPO is a significant stage in the growth of many small businesses, as it provides
them with access to the public capital market and also increases their credibility and exposure.
Becoming a public entity involves significant changes for a small business, though, including a
loss of flexibility and control for management. In many cases, however, an IPO may be the only
means left of financing growth and expansion. The decision to go public is sometimes influenced
by venture capitalists or founders who wish to cash in on their early investment1.

Staging an IPO is also a very time-consuming and expensive process. A small business interested
in going public must apply to the Securities and Exchange Commission (SEC) for permission to
sell stock to the public. The SEC registration process is quite complex and requires the company
to disclose a variety of information to potential investors. The IPO process can take as little as
six months or as long as two years, during which time management's attention is distracted away
from day-to-day operations. It can also cost a company between $50,000 and $250,000 in
underwriting fees, legal and accounting expenses, and printing costs1.

Overall, going public is a complex decision that requires careful consideration and planning.
Experts recommend that small business owners consider all the alternatives first (such as
securing venture capital, forming a limited partnership or joint venture, or selling shares through
private placement, self-underwriting, or a direct public offering), examine their current and
future capital needs, and be aware of how an IPO will affect the availability of future financing1.

According to Jennifer Lindsey in her book The Entrepreneur's Guide to Capital, the ideal
candidate for an IPO is a small-to medium-sized company in an emerging industry, with annual
revenues of at least $10 million and a profit margin of over 10 percent of revenues. It is also
important that the company have a stable management group, growth of at least 10 percent
annually, and capitalization featuring no more than 25 percent debt. Companies that meet these
basic criteria still need to time their IPO carefully in order to gain the maximum benefits.
Lindsey suggested going public when the stock markets are receptive to new offerings, the
industry is growing rapidly, and the company needs access to more capital and public recognition
to support its strategies for expansion and growth1.
THE PROCESS OF GOING PUBLIC
Once a small business has decided to go public, the first step in the IPO process is to select an
underwriter to act as an intermediary between the company and the capital markets. Joubert
recommended that small business owners solicit proposals from a number of investment banks,
then evaluate the bidders on the basis of their reputation, experience with similar offerings,
experience in the industry, distribution network, record of post-offering support, and type of
underwriting arrangement. Other considerations include the bidders' valuation of the company
and recommended share price1.

There are three basic types of underwriting arrangements: best efforts, which means that the
investment bank does not commit to buying any shares but agrees to put forth its best effort to
sell as many as possible; all or none, which is similar to best efforts except that the offering is
canceled if all the shares are not sold; and firm commitment, which means that the investment
bank purchases all the shares itself. The firm commitment arrangement is probably best for the
small business, since the underwriter holds the risk of not selling the shares. Once a lead
underwriter has been selected, that firm will form a team of other underwriters and brokers to
assist it in achieving a broad distribution of the stock1.

The next step in the IPO process is to assemble an underwriting team consisting of attorneys,
independent accountants, and a financial printer. The attorneys for the underwriter draft all the
agreements, while the attorneys for the company advise management about meeting all SEC
regulations. The accountants issue opinions about the company's financial statements in order to
reassure potential investors. The financial printer handles preparation of the prospectus and other
written tools involved in marketing the offering1.

After putting together a team to handle the IPO, the small business must then prepare an initial
registration statement according to SEC regulations. The main body of the registration statement
is a prospectus containing detailed information about the company, including its financial
statements and a management analysis. The management analysis is perhaps the most important
and time-consuming part of the IPO process. In it, the small business owners must
simultaneously disclose all of the potential risks faced by the business and convince investors
that it is a good investment. This section is typically worded very carefully and reviewed by the
company's attorneys to ensure compliance with SEC rules about truthful dis-closure1.

The SEC rules regarding public stock offerings are contained in two main acts: the Securities Act
of 1933 and the Securities Act of 1934. The former concerns the registration of IPOs with the
SEC in order to protect the public against fraud, while the latter regulates companies after they
have gone public, outlines registration and reporting procedures, and sets forth insider trading
laws. Upon completion of the initial registration statement, it is sent to the SEC for review.
During the review process, which can take up to two months, the company's attorneys remain in
contact with the SEC in order to learn of any necessary changes. Also during this time, the
company's financial statements must be audited by independent accountants in accordance with
SEC rules. This audit is more formal than the usual accounting review and provides investors
with a much higher degree of assurance about the company's financial position1.
Throughout the SEC review periodwhich is sometimes called the "cooling off" or "quiet"
periodthe company also begins making controlled efforts to market the offering. The company
distributes a preliminary prospectus to potential investors, and the small business owners and top
managers travel around to make personal presentations of the material in what are known as
"road shows." It is important to note, however, that management cannot disclose any further
information beyond that contained in the prospectus during the SEC review period. Other
activities taking place during this time include filing various forms with different states in which
the stock will be sold (the differing state requirements are known as "blue sky laws") and holding
a due diligence meeting to review financial statements one last time1.

At the end of the cooling off period, the SEC provides comments on the initial registration
statement. The company then must address the comments, agree to a final offering price for the
shares, and file a final amendment to the registration statement. Technically, the actual sale of
stock is supposed to become effective 20 days after the final amendment is filed, but the SEC
usually grants companies an acceleration so that it becomes effective immediately. This
acceleration grows out of the SEC's recognition that the stock market can change dramatically
over a 20-day period. The actual selling of shares then takes place, beginning on the official
offering date and continuing for seven days. The lead investment banker supervises the public
sale of the security. During the offering period, the investment bankers are permitted to
"stabilize" the price of the security by purchasing shares in the secondary market. This process is
called pegging, and it is permitted to continue for up to ten days after the official offering date.
The investment bankers may also support the offering through overallotment, or selling up to 15
percent more stock when demand is high1.

After a successful offering, the underwriter meets with all parties to distribute the funds and
settle all expenses. At that time the transfer agent is given authorization to forward the securities
to the new owners. An IPO closes with the transfer of the stock, but the terms of the offering are
not yet completed. The SEC requires the filing of a number of reports pertaining to the
appropriate use of the funds as described in the prospectus. If the offering is terminated for any
reason, the underwriter returns the funds to the investors1.

What are the advantages and disadvantages for a company going

public?
An initial public offering (IPO) is the first sale of stock by a company. Small companies looking
to further the growth of their company often use an IPO as a way to generate the capital needed
to expand. Although further expansion is a benefit to the company, there are both advantages and
disadvantages that arise when a company goes public2.

There are many advantages for a company going public. As said earlier, the financial benefit in
the form of raising capital is the most distinct advantage. Capital can be used to fund research
and development, fund capital expenditure or even used to pay off existing debt. Another
advantage is an increased public awareness of the company because IPOs often generate
publicity by making their products known to a new group of potential customers2.
Subsequently this may lead to an increase in market share for the company. An IPO also may be
used by founding individuals as an exit strategy. Many venture capitalists have used IPOs to cash
in on successful companies that they helped start-up2.

Even with the benefits of an IPO, public companies often face many new challenges as well. One
of the most important changes is the need for added disclosure for investors. Public companies
are regulated by the Securities Exchange Act of 1934 in regard to periodic financial reporting,
which may be difficult for newer public companies. They must also meet other rules and
regulations that are monitored by the Securities and Exchange Commission (SEC). More
importantly, especially for smaller companies, is the cost of complying with regulatory
requirements can be very high. These costs have only increased with the advent of the Sarbanes-
Oxley Act. Some of the additional costs include the generation of financial reporting documents,
audit fees, investor relation departments and accounting oversight committees2.

Public companies also are faced with the added pressure of the market which may cause them to
focus more on short-term results rather than long-term growth. The actions of the company's
management also become increasingly scrutinized as investors constantly look for rising profits.
This may lead management to perform somewhat questionable practices in order to boost
earnings2.

Before deciding whether or not to go public, companies must evaluate all of the potential
advantages and disadvantages that will arise. This usually will happen during the underwriting
process as the company works with an investment bank to weigh the pros and cons of a public
offering and determine if it is in the best interest of the company2.

ADVANTAGES OF GOING PUBLIC

The primary advantage a small business stands to gain through an initial public stock offering is
access to capital. In addition, the capital does not have to be repaid and does not involve an
interest charge. The only reward that IPO investors seek is an appreciation of their investment
and possibly dividends. Besides the immediate infusion of capital provided by an IPO, a small
business that goes public may also find it easier to obtain capital for future needs through new
stock offerings or public debt offerings. A related advantage of an IPO is that it provides the
small business's founders and venture capitalists with an opportunity to cash out on their early
investment. Those shares of equity can be sold as part of the IPO, in a special offering, or on the
open market sometime after the IPO. However, it is important to avoid the perception that the
owners are seeking to bail out of a sinking ship, or the IPO is unlikely to be a success1.

Another advantage IPOs hold for small businesses is increased public awareness, which may
lead to new opportunities and new customers. As part of the IPO process, information about the
company is printed in newspapers across the country. The excitement surrounding an IPO may
also generate increased attention in the business press. There are a number of laws covering the
disclosure of information during the IPO process, however, so small business owners must be
careful not to get carried away with the publicity. A related advantage is that the public company
may have enhanced credibility with its suppliers, customers, and lenders, which may lead to
improved credit terms1.
Yet another advantage of going public involves the ability to use stock in creative incentive
packages for management and employees. Offering shares of stock and stock options as part of
compensation may enable a small business to attract better management talent, and to provide
them with an incentive to perform well. Employees who become part-owners through a stock
plan may be motivated by sharing in the company's success. Finally, an initial public offering
provides a public valuation of a small business. This means that it will be easier for the company
to enter into mergers and acquisitions, because it can offer stock rather than cash1.

DISADVANTAGES OF GOING PUBLIC

The biggest disadvantages involved in going public are the costs and time involved. Experts note
that a company's management is likely to be occupied with little else during the entire IPO
process, which may last as long as two years. The small business owner and other top managers
must prepare registration statements for the SEC, consult with investment bankers, attorneys, and
accountants, and take part in the personal marketing of the stock. Many people find this to be an
exhaustive process and would prefer to simply run their company1.

Another disadvantage is that an IPO is extremely expensive. In fact, it is not unusual for a small
business to pay between $50,000 and $250,000 to prepare and publicize an offering. In his article
for The Portable MBA in Finance and Accounting, Paul G. Joubert noted that a small business
owner should not be surprised if the cost of an IPO claims between 15 and 20 percent of the
proceeds of the sale of stock. Some of the major costs include the lead underwriter's commission;
out-of-pocket expenses for legal services, accounting services, printing costs, and the personal
marketing "road show" by managers; .02 percent filing costs with the SEC; fees for public
relations to bolster the company's image; plus ongoing legal, accounting, filing, and mailing
expenses. Despite such expense, it is always possible that an unforeseen problem will derail the
IPO before the sale of stock takes place. Even when the sale does take place, most underwriters
offer IPO shares at a discounted price in order to ensure an upward movement in the stock during
the period immediately following the offering. The effect of this discount is to transfer wealth
from the initial investors to new shareholders1.

Other disadvantages involve the public company's loss of confidentiality, flexibility, and control.
SEC regulations require public companies to release all operating details to the public, including
sensitive information about their markets, profit margins, and future plans. An untold number of
problems and conflicts may arise when everyone from competitors to employees know all about
the inner workings of the company. By diluting the holdings of the company's original owners,
going public also gives management less control over day-to-day operations. Large shareholders
may seek representation on the board and a say in how the company is run. If enough
shareholders become disgruntled with the company's stock value or future plans, they can stage a
takeover and oust management. The dilution of ownership also reduces management's flexibility.
It is not possible to make decisions as quickly and efficiently when the board must approve all
decisions. In addition, SEC regulations restrict the ability of a public company's management to
trade their stock and to discuss company business with outsiders1.

Public entities also face added pressure to show strong short-term performance. Earnings are
reported quarterly, and shareholders and financial markets always want to see good results.
Unfortunately, long-term strategic investment decisions may tend to have a lower priority than
making current numbers look good. The additional reporting requirements for public companies
also add expense, as the small business will likely need to improve accounting systems and add
staff. Public entities also encounter added costs associated with handling shareholder relations1.

VALUATION MULTIPLES
Valuation multiples are the quickest way to value a company, and are useful in comparing similar
companies (comparable company analysis). They attempt to capture many of a firm's operating
and financial characteristics (e.g. expected growth) in a single number that can be multiplied by
some financial metric (e.g. EBITDA) to yield an enterprise or equity value. Multiples are
expressed as a ratio of capital investment to a financial metric attributable to providers of that
capital3.

One very important point to note about multiples is the connection between the numerator and
denominator. Since enterprise value (EV) equals equity value plus net debt, EV multiples are
calculated using denominators relevant to all stakeholders (both stock and debt holders).
Therefore, the relevant denominator must be computed before interest expense, preferred
dividends, and minority interest expense. On the other hand, equity value multiples are
calculated using denominators relevant to equity holders, only. Therefore, the relevant
denominator must be computed after interest, preferred dividends, and minority interest
expense3.

For example, an EV/Net Income multiple is meaningless because the numerator applies to
shareholders and creditors, but the denominator accrues only to shareholders. Similarly, an
Equity Value/EBITDA multiple is meaningless because the numerator applies only to
shareholders, while the denominator accrues to all holders of capital. With this understanding of
the relationship between numerator and denominator, we can invent virtually any multiple we
like to value a business, so long as the multiple is, of course, relevant to that business3.

The choice of multiple(s) in valuing and comparing companies depends on the nature of the
business or the industry in which the business operates. For example, EV/(EBITDACapEx)
multiples are often used to value capital intensive businesses like cable companies, but would be
inappropriate for consulting firms. To figure out which multiples apply to a business you are
considering, try looking at equity research reports of comparable companies to see what analysts
are using3.

Enterprise value multiples are better than equity value multiples because the former allow for
direct comparison of different firms, regardless of capital structure. Recall, that the value of a
firm is theoretically independent of capital structure. Equity value multiples, on the other hand,
are influenced by leverage. For example, highly levered firms generally have higher P/E
multiples because their expected returns on equity are higher. Additionally, EV multiples are
typically less affected by accounting differences, since the denominator is computed higher up
on the income statement3.
In practice, we generally refer to some multiples using the denominator only, because the
numerator is implied. For example, when talking about the EV/EBITDA multiple, we would
simply say "EBITDA multiple", because the only sensible numerator is EV3.

Multiple Comments

EV/EBITDA is one of the most commonly used valuation metrics, as EBITDA is

EV /
commonly used as a proxy for cash flow available to the firm. EV/EBITDA is often
EBITDA
in the range of 6.0x to 18.0x.

When depreciation and amortization expenses are small, as in the case of a non-
capital-intensive company such as a consulting firm, EV/EBIT and EV/EBITDA will
EV / be similar. Unlike EBITDA, EBIT recognizes that depreciation and amortization,
EBIT while non-cash charges, reflect real expenses associated with the utilization and wear
of a firm's assets that will ultimately need to be replaced. EV/EBIT is often in the
range of 10.0x to 25.0x.

When a company has negative EBITDA, the EV/EBITDA and EV/EBIT multiples
will not be material. In such cases, EV/Sales may be the most appropriate multiple to
use. EV/Sales is commonly used in the valuation of companies whose operating costs
EV / Sales still exceed revenues, as might be the case with nascent Internet firms, for example.
However, revenue is a poor metric by which to compare firms, since two firms with
identical revenues may have wildly different margins. EV/Sales multiples are often in
the range of 1.00x to 3.00x

P/E is one of the most commonly used valuation metrics, where the numerator is the
price of the stock and the denominator is EPS. Note that the P/E multiple equals the
ratio of equity value to net Income, in which the numerator and denominator are both
P/E
are divided by the number of fully diluted shares. EPS figures may be either as-
reported or adjusted as described below. P/E multiples are often in the range of 15.0x
to 30.0x.

P/E/G The PEG ratio is simply the P/E ratio divided by the expected EPS growth rate, and is
often in the range of 0.50x to 3.00x. PEG ratios are more flexible than other ratios in
that they allow the expected level of growth to vary across companies, making it
 easier to make comparisons between companies in different stages of their life cycles.
There is no standard time frame for measuring expected EPS growth, but
practitioners typically use a long-term, or 5-year, growth rate.

Calculating the Denominator (EBITDA, Net Income, etc.)

The denominator may be either a stock or a flow. A stock is measured at a single point in time
(e.g. book value), while a flow is measured over a period of time (e.g. EBITDA). We will focus
our discussion here on flows3.

Historical valuation multiples are usually calculated over the last twelve month (LTM) period. To
calculate the LTM EBITDA, for example, add the EBITDA from the most recent stub period to
the latest full-year EBITDA, and subtract the EBITDA from the corresponding stub period last
year. Publicly traded U.S. companies report earnings on a quarterly basis, but many publicly
traded foreign firms only report earnings every 6 months on a semi-annual basis. Therefore, it is
possible that the LTM periods for some foreign firms will not chronologically align with the
LTM periods for U.S. firms3.

Most publicly traded companies are valued based on their projected, rather than historical,
earnings and cash flows. Projections, or forward estimates, are made by equity research analyst
estimates, and often averaged for use in calculating valuation multiples. Forward estimates can
be obtained from sources like Bloomberg, First Call, and IBES. These projections are usually
provided on a calendar year basis for consistency, but it is necessary to verify that all such
estimates use the same yearly basis (either calendar or fiscal) to make apples-to-apples
comparisons3.

Adjust the denominator to exclude the effects of extraordinary and non-recurring items such as
restructuring charges, one-time gains/losses, accounting changes, legal settlements, discontinued
operations, and asset impairment charges. Also, if non-controlling interest is excluded from the
calculation of EV, the portion of EBITDA and EBIT attributable to the non-controlling interest
should also be excluded from the denominator3.

When using multiples to compare similar companies in a peer group as part of a comparable
companys analysis, it is necessary to ensure that the comparison is "apples-to-apples". This
means that the denominators of all multiples compared should span the same time period,
whether historical or projected, and be adjusted for the same items, such as stock-based
compensation3.

Discounted Cash Flow (DCF)

What is a 'Discounted Cash Flow (DCF)'
A discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an
investment opportunity. DCF analysis uses future free cash flow projections and discounts them
to arrive at a present value estimate, which is used to evaluate the potential for investment. If the
value arrived at through DCF analysis is higher than the current cost of the investment, the
opportunity may be a good one4.

Calculated as:

DCF is also known as the Discounted Cash Flows Model.

BREAKING DOWN 'Discounted Cash Flow (DCF)'

There are several variations when it comes to assigning values to cash flows and the discount
rate in a DCF analysis. But while the calculations involved are complex, the purpose of DCF
analysis is simply to estimate the money an investor would receive from an investment, adjusted
for the time value of money4.

The time value of money is the assumption that a dollar today is worth more than a dollar
tomorrow. For example, assuming 5% annual interest, $1.00 in a savings account will be worth
$1.05 in a year. Due to the symmetric property (if a=b, then b=a), we must consider $1.05 a year
from now to be worth $1.00 today. When it comes to assessing the future value of investments, it
is common to use the weighted average cost of capital (WACC) as the discount rate4.

For a hypothetical Company X, we would apply DCF analysis by first estimating the firm's
future cash flow growth. We would start by determining the company's trailing twelve month
(ttm) free cash flow (FCF), equal to that period's operating cash flow minus capital expenditures.
Say that Company X's ttm FCF is $50 m. We would compare this figure to previous years' cash
flows in order to estimate a rate of growth. It is also important to consider the source of this
growth. Are sales increasing? Are costs declining? These factors will inform assessments of the
growth rate's sustainability4.

Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then
5% in the following three. After a few years, you may apply a long-term cash flow growth rate,
representing an assumption of annual growth from that point on. This value should probably not
exceed the long-term growth prospects of the overall economy by too much; we will say that
Company X's is 3%. You will then calculate a WACC; say it comes out to 8%. The terminal
value, or long-term valuation the company's growth approaches, is calculated using the Gordon
Growth Model4:
Terminal value = projected cash flow for final year (1 + long-term growth rate) / (discount rate -
long-term growth rate) 4

Now you can estimate the cash flow for each period, including the the terminal value4:

Year 1 = 50 * 1.10 55

Year 2 = 55 * 1.10 60.5

Year 3 = 60.5 * 1.05 63.53

Year 4 = 63.53 * 1.05 66.70

Year 5 = 66.70 * 1.05 70.04

Terminal value = 70.04 (1.03) / (0.08 - 0.03) 1,442.75

Finally, to calculate Company X's discounted cash flow, you add each of these projected cash
flows, adjusting them for present value using the WACC4:

DCFCompany X = (55 / 1.081) + (60.5 / 1.082) + (63.53 / 1.083) + (66.70 / 1.084) + (70.04 / 1.085) +
(1,442.75 / 1.085) = 1231.83

$1.23 b is our estimate of Company X's present enterprise value. If the company has net debt,
this needs to be subtracted, as equity holders' claims to a company's assets are subordinate to
bondholders'. The result is an estimate of the company's fair equity value. If we divide that by the
number of shares outstandingsay 10 mwe have a fair equity value per share of $123.18,
which we can compare with the market price of the stock. If our estimate is higher than the
current stock price, we might consider Company X a good investment4.

Discounted cash flow models are powerful, but they are only as good as their imports. As the
axiom goes, "garbage in, garbage out". Small changes in inputs can result in large changes in the
estimated value of a company, and every assumption has the potential to erode the estimate's
accuracy4.
1 - http://www.referenceforbusiness.com/small/Inc-Mail/Initial-Public-
Offerings.html#ixzz40t7UFr2p

2 - http://www.investopedia.com/ask/answers/06/ipoadvantagedisadvantage.asp#ixzz40t85dHYi

3 - https://macabacus.com/valuation/multiples

4 - http://www.investopedia.com/terms/d/dcf.asp#ixzz40tC8OE00