Reference no: EM132236280

Case : What Are We Really Worth?

(Valuation of Common Stock)

When Matt concocted his cleaning compound, some twenty years ago all that his wife,Edith, and he were trying to do was to come up with a sweeter, gentler, yet tougher, cleaningproduct. Little did he realize that someday he would be the proud owner of a multi-million dollarfirm debating whether or not to sell stock to the public?After having peddled vacuum cleaners and floor wax products at state fairs and tradeshows throughout the Midwest, Matt and Edith Short realized that there was a dire need for acleaning and polishing product that was free from harsh chemicals, environmentally friendly, andtough on dirt and grime. So Matt spent many hours in his garage at their country home inAppleton, Wisconsin experimenting with various oils, cleansing agents, and extracts until hefinally came up with what he proudly calls, “The perfect cleaner and polish.” It was the purecitrus oil made from the peels of Valencia oranges that did the trick. Not only was the mixturesweet smelling, it was an effective solvent and degreaser which worker wonders on their kitchencabinets at home.So spurred on by their close friends, the Shorts formed their company, Citrus Glow(which they later changed to Citrus Glow International), in December of 1984 and took their dogand pony show on the road. Initially, they sold their products mainly through “word of mouth”advertising at state fairs, and home and garden shows, but later with the help of their 3 children,Lisa, Dan and Joe, they used direct response television, direct mail, and e-commerce channels tohelp grow the company’s revenues at a phenomenal rate. When the Home Shopping Networkagreed to let them show off their merchandise about 5 years ago, major retailers like Wal-Martand Costco took notice and started stocking Citrus Glow products on their shelves.Within twenty years, their sales had grown to over $500 million and their productionfacilities were beginning to feel the strain. Their product line had expanded to include airfresheners, soap bars, liquid soaps, spot removers, and a variety of cleaning tools. Through allthis success, the Shorts always focused on customer need and satisfaction, always encouragingcustomers to provide them with feedback and testimonials. Their latest addition, i.e. anindustrial-strength cleaner and wood protector, seemed to be gaining wide acceptance both in theUnited States and overseas.Matt, who was nearing 75 years on age, knew that they would need to raise significantamounts of capital if they wanted to keep growing and expanding their product line. Still activelyinvolved in the business, he had asked the rest of his family for their suggestions regarding thepossibility of going public by issuing an initial public offering (IPO). Lisa and Joe stronglysupported the idea because they felt that with competitors coming up with substitute products,they needed to stay ahead of the game. Dan, on the other hand, disagreed and recommended thatthey outsource the production and concentrate on their marketing efforts. He preferred the firm tostay private, thereby, relying less on external capital and retaining control.After carefully weighing all the factors, Matt decided to explore the possibility of raisingmoney via an IPO. “Dan, Lisa, and Joe” he said, “the three of you have MBAs from some of themost prestigious business schools in the country. I’m sure you guys can figure out WHAT AREWE REALLY WORTH! I hate to depend on the investment banking folks to come up with theright price. Why don’t the three of you put your heads together and figure out what is the minimum price that we should sell our stock for if we were to go public. Let’s say we sell 30million shares. I’m sure we can find a way of retaining control of a large portion of theshareholding and still raise the much-needed cash. Dan’s point of loss of control is a good one,but I am not in favor of outsourcing production. Our success has come from our quality and thatwould likely be jeopardized if we let others produce the product.So Lisa, Dan, and Joe got to work. They realized that they would need industry andcompetitors’ financial data. Table 1 presents key valuation data for 3 of their major publiclytraded competitors in the personal and household products industry sector. Table 2 and 3 presentCitrus Glow International’s 5-year income statements and balance sheets respectively.Lisa preferred to use the Corporate Value Model whereby the firm’s value was estimatedas the sum of its discounted free-cash flows. Free cash flows were estimated by subtracting thefirm’s net capital investment from the year’s net operating profits after taxes (NOPAT) and werediscounted at a suitable risk-adjusted discount rate (weighted average cost of capital). Lisaassumed that the firm’s free cash flows would grow at a rate of 20% during the first year, 10%during the second year, and finally settle down to a long-term growth rate of 6% thereafter. Thefirm’s equity value was calculated by subtracting out the firm’s outstanding debt owed tocreditors from the overall value. Lisa used a risk-free rate of 4%, a market risk premium of 8%,and the average beta of the three competitors when determining the firm’s cost of equity.Having worked on various valuation projects for a major consulting firm, Dan was astrong advocate of the use of price-ratio models for valuing common stock. His method involvedusing suitable price-earnings, price-sales, price-book value, and price-cash flow multiples inconjunction with forecasted values for the firm’s earnings, sales, book value, and cash flowsrespectively. Dan used the 4-year average compounded growth rate when forecasting the relevantvariables and then discounted the year-ahead price forecasts by the required rate of return onequity (based on the Capital Asset Pricing Model using the same inputs that Lisa used).Joe’s old finance professor, Dr. Larry Brown, on the other hand, had indoctrinated him inthe art of common stock valuation via the discounting of future dividends. “Always use arealistic required rate of return and various growth rate scenarios in conjunction with industrybenchmarks, when valuing growth companies,” was Dr. Brown’s advice. Accordingly, Johndecided to use a variable growth rate model to value the firm’s equity.“What will we do if our three estimates are totally different?” asked Lisa looking ratherconcerned.“We’ll have to go back to the drawing tables and examine our inputs,” said the ever-resourceful Dan, “We’ll each have to be within a reasonable ballpark or Dad’s going to flip”

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.

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 30 million shares?

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. How far off would Joe’s price estimate be 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.

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.