Understanding Valuation MDrake-COlinger

Understanding Valuation and the ESOP Valuation Report IOWA-NEBRASKA ESOP CHAPTER CONFERENCE 2013 WINTER CONFERENCE – CORALVILLE, IOWA

Matthew Drake Senior Associate

630.413.5589 [email protected]

Craig Olinger Financial Consultant


2

VALUATION PROCESS The Essentials….

The Process…

A typical valuation engagement lasts anywhere from 30 to 45 days.

Step 4 Build valuation models

Step 7 Present conclusions of value

Step 2 Collection of Data • Background & history • Financial statements • Budgets/Projections • Customer lists

Step 6 Prepare reports/deliverables

Step 5 Review of projections with management team

Step 8 Complete engagement and issue final reports/deliverables

Step 1 Engagement

Step 3 On-site due diligence

3

CONCEPTS OF VALUATION Approaches to Value

Income Approach Market Approach Asset-Based Approach

There are two widely accepted methods used under this approach: — Discounted cash flow method — Capitalized earnings method

Discounted Cash Flow Method (“DCF”)

— The DCF method involves projecting normalized free cash flows and discounting them back to present value using a discount rate

— The discount rate should reflect the degree of perceived risk associated with achieving the Company’s earnings expectations

Capitalized Earnings Method

— This approach determines the value of a business by looking at the historical cash flow results instead of expected future cash flows.

— This is done by taking historical earnings and dividing them by the capitalization rate (discount rate – growth rate)

The most widely accepted method used under this approach: — Underlying Asset Method

Underlying Asset Method — This method analyzes the individual

assets and liabilities comprising the business

— Involves the estimation of the current reproduction cost of the assets, less an estimate of accrued depreciation to reflect physical, functional, and economic obsolescence

This approach is typically not applied in the valuation of a going concern

Reserved for companies that are often in the liquidation process or comprised of large fixed assets (i.e. REITs)

There are two widely accepted methods used under this approach: — Guideline public company method — M&A comparable method

Guideline Public Company Method

— This method assesses the subject company relative to a group of similar, publicly traded companies

— Applies valuation multiples derived from this public company group to the subject company’s earnings

M&A Comparable Method

— This is another commonly used method that focuses on the terms, prices, and conditions found in sales of companies in the subject company’s respective industry

— Transactions multiples are screened and then applied to the subject company’s earnings

4

KEY VALUATION DRIVERS Valuation Basics

External Drivers Internal Drivers

Market multiples Growth prospects

Lending conditions Profitability

Interest rates Revenue sources

Industry trends Balance sheet

Investor psychology Intangible assets

Capital markets – debt/equity Management team

Economic policies Customer diversification

Political environment Size

International markets Capital requirements

Competition Litigation & Environmental

What do we look for…

We want to reflect the economics of…

— The Company itself

— Its competitive marketplace

— The general economy and capital markets

— Our goal is to think like investors

As such, we must look inside and outside of the Company

— Established valuation approaches, such as the income and market approach, follow these concepts

This is how the market prices stock

— Research analysts developing recommendations

— Investment bankers considering mergers and acquisitions

— Corporate development professionals evaluating acquisitions

— Sub-debt/mezzanine lenders pricing warrants on their facilities

We want to “MIMIC” the marketplace

What drives company value?

5

KEY VALUATION DRIVERS Equity Value can Grow in Two Ways…

Pay Off Debt Equity Starting Point

Net Working Capital (NWC)

Fixed Assets & Other Assets

Long-Term Liabilities

Equity

NWC


Equity

Grow Asset Values

NWC



Equity

6

KEY VALUATION DRIVERS What Cash Flow Streams Are We Solving To…?

NWC



Equity

Invested Capital Value

Equity Value

NWC



Equity

Debt-free streams provide a return on invested capital Discounting them to present value leads to INVESTED

CAPITAL VALUE Debt-free earnings streams include:

– EBIAT (earnings before interest after tax) – Debt-free cash flow – EBITDA – EBIT

Equity streams provide a return on equity Discounting them to present value leads to EQUITY VALUE Equity earnings streams include:

– Net income – Net cash flow – Earnings before taxes

7

KEY VALUATION DRIVERS Adjustments to Earnings

Examples of Adjustments/Add-backs to Earnings

Excess compensation

Non-continuing compensation

Personal (entertainment) expenses (cars, plane)

Extraordinary legal fees

Extraordinary professional fees

Significant bad debt/inventory write-offs

Income/expenses from discontinued operations

Environmental litigation/remediation

Excess employee benefits/compensation

Gain on sale of assets

Investment income

What Do We Look For…

In order to reflect an accurate representation of the Company’s true earnings, certain items may be adjusted

— Income/expenses deemed to be one-time in nature

— Expenses that are in excess of “normal” market levels

— Expenses that will no longer occur in the future

What Qualifies as an Earnings Adjustment

8

KEY VALUATION DRIVERS How Multiples Are Calculated…

EBITDA Multiple Calculation

($000’s)

Equity Value $10,000

Total Debt $2,000

Invested Capital Value $12,000

Company EBITDA $2,000

EBITDA Multiple 6.0x

(IC/EBITDA) ($12,000/2,000)

Invested Capital Value Equity Value

Net Income Multiple Calculation

($000’s)

Invested Capital $12,000

Less: Total Debt -$2,000

Equity Value $10,000

Company Net Income $1,000

Net Income Multiple 10.0x

(Equity Value/NI) ($10,000/1,000)

Income Approach

10

INCOME APPROACH Discounted Cash Flow Method

DCF – Looking “Inside” the Company DCF Example…

DCF modeling can vary in duration

— Single or multiple-year models are used

— Ultimately, we have to value all future years

— Typically, a “discrete” period and a “terminal value” are used

Revenue, expenses, reinvestment, and other assumptions are reflected in the DCF

Prairie uses a 10-year DCF model

What causes value change?

— Value changes directly as revenue and profitability expectations rise and fall

— Value also changes as risks and costs of capital fluctuate

Capitalization rate of 11.25% used

(K-g) = 15.25%-4.0%

Free Cash Flow 2011 2012 2013 2014 2015 ... 2020

EBIAT 2,924.8$ 3,545.8$ 4,041.5$ 4,385.9$ 4,543.4$ 6,177.9$

D&A 751.4 1,986.5 2,186.9 2,399.3 2,622.3 2,226.0

Change in Working Capital 2,295.9 (949.3) (727.8) (480.3) (424.3) (421.0)

Capital Expenditures (1,000.0) (1,987.9) (2,186.7) (2,317.9) (2,433.8) (2,989.5)

Debt-Free Cash Flow 3,265.3 2,595.1 3,313.8 3,986.9 4,307.6 4,993.4

Discount Factor @ 15.25% 0.9426 0.8179 0.7097 0.6158 0.5343 0.2628

Midyear Adjustment Factor 1.0300 1.0735 1.0735 1.0735 1.0735 1.0735

NPV of Free Cash Flows 3,170.2 2,278.6 2,524.6 2,635.5 2,470.7 1,408.6

Sum of NPV of FCFs 22,073.8

Perpetuity Growth Model

Present Value of CF (Years: 1 -10) 22,073.8$

Terminal Value (CF10 + g) / (K-g) 53,219.7$

Present Value Factor 0.282

PV of Terminal Value 15,012.6

Enterprise Value (Years: 1-10 + TV) 37,086.3$

Equity Value Conclusion

Enterprise Value 37,086.3$ Less: Total Funded Debt (7,500.0) Equity Value (1) 29,586.3$

(1) Based on a marketable minority value premise or "publicly traded equivalent"

(2) K = Discount Rate, g = Long-Term Growth Rate

INCOME APPROACH Developing the Discount Rate

Discount Rate Discount Rate Example

The discount rate is used to discount future cash flow streams back to present value

— Time value of money

— Risk

We generally project the cash flow of the Company on a debt free basis

— In doing so, we use the weighted average cost of capital (WACC) to calculate the discount rate

— Projected rate of return that debt and equity holders would require to invest in this particular business

The WACC involves:

— The cost of equity (Capital Asset Pricing Model)

— The cost of debt capital for the Company

— Calculating the WACC by multiplying the returns required for each component of capital by its contribution to total capital

Determination of an appropriate discount rate cannot be reduced to a simple mathematical formula

— It requires judgment and knowledge developed from experience in securities valuation

CAPM Calculation (Ke = 1 + (2*3) + 4)Risk-free Rate (1) 4.13%Equity Risk Premium (2) 6.70%Beta (3) 1.15Subjective / Small Comp Risk Premium (4) 6.36%Cost of Equity (Ke) 18.20%

Cost of Debt 6.00%Tax Rate 40.00%After - Tax Cost of Debt (Kd) 3.60%

WACC = (Ke * %E) + (Kd * %D)Equity % of Capital 79.78%Debt % of Capital 20.22%

Calculated WACC (rounded) 15.25%

(1) U.S. Treasury yield 20-year constant maturity as of the valuation date, Fed Statistical Release(2) Ibbotson Associates' "SBBI Valuation Yearbook" long-term horizon(3) Beta derived from public company peer group, relevered with subject company's capital structure(4) Ibbotson Associates' "SBBI Valuation Yearbook" 10th decile

Market Approach

MARKET APPROACH Public Guideline Company Method

Like the income approach, the market approach has “stream-defined” methods

PGC – Looking “Outside” the Company PGC Architecture…

Comparative public companies (or comparative private transactions) are selected as a representative group of alternate investments

— Price to earnings (P/E) multiples are extracted from market data

— They are applied to comparable factors for the Company

Issue in today’s market: Is our company on the same path?

Value may be a significant function of THEIR ECONOMICS

Sources of valuation multiples

— Net income

— Cash flow

— EBIT

— EBITDA

— Revenue

— Book value

Using Invested Capital Multiples Using Equity Multiples

EBIAT, EBIT, or EBITDA Pretax Income or NI

X X

Invested Capital Multiples Equity Multiples

= Invested Capital Value = Equity Value

- Interest Bearing Debt

= Equity Value

MARKET APPROACH Public Guideline Company Method

PGC Example…

Public Comparable Method Valuation Summary ( in thousands)Company Adjustment Enterprise Less: Equity

Equity Multiples Earnings Median 15.0% Value Total Debt ValueNear Term P/E - 2011 $2,900.0 11.0x 9.4x $27,115.0 NA $27,115.0Latest P/E - 2010 1,100.0 16.0x 13.6x 14,960.0 NA 14,960.0Five Year Average P/E 2,000.0 17.0x 14.5x 28,900.0 NA 28,900.0

Near Term CF - 2011 $4,700.0 9.0x 7.7x 35,955.0 NA 35,955.0Latest CF - 2010 2,700.0 11.0x 9.4x 25,245.0 NA 25,245.0Five Year Average CF 3,400.0 12.0x 10.2x 34,680.0 NA 34,680.0

Invested Capital MultiplesNear Term EBIT - 2011 $4,900.0 8.0x 6.8x 33,320.0 (7,500.0) 25,820.0Latest EBIT - 2010 2,000.0 10.0x 8.5x 17,000.0 (7,500.0) 9,500.0Five Year Average EBIT 3,500.0 11.0x 9.4x 32,725.0 (7,500.0) 25,225.0

Near Term EBITDA - 2011 $6,700.0 7.0x 6.0x 39,865.0 (7,500.0) 32,365.0Latest EBITDA - 2010 3,600.0 8.0x 6.8x 24,480.0 (7,500.0) 16,980.0Five Year Average EBITDA 5,000.0 9.0x 7.7x 38,250.0 (7,500.0) 30,750.0

IC to Revenue 30,300.0 1.5x 1.3x 38,131.8 (7,500.0) 30,631.8

Valuation Conclusions MedianIndicated Equity Value 27,115.0

MARKET APPROACH M&A Comparable Method

Continuing to Look “Outside” M&A Market Statistics…

Private company M&A transactions

— The data is derived from purchased databases or press releases

— It’s generally less reliable than public company data; however, at times, could be more indicative of current market pricing

M&A data

— Publically announced transactions (public company deals)

— Publicly disclosed transactions (private company deals)

— Summarized databases sorted by industry and company size

Some sources of M&A data

— Capital IQ

— MergerStat

— Done Deals

— GF Data Resources

MARKET APPROACH M&A Comparable Method

Application of the Method…

M&A Comparable Method Example

($000’s)

Adjusted EBITDA $6,679.0

Multiple 5.7x

Invested Capital Value $38,070.3

Less: Total Debt ($7,500.0)

Equity Value $30,570.3

Valuation Premises & Conclusion

VALUATION PREMISES & CONCLUSIONS Standards of Value

Controlling Interest

Marketable Minority

Non-Marketable Minority

Change of control transaction Synergistic premium may be warranted Value of Enterprise as a whole Acquisition value Control premium

Value “as if” publicly traded Prairie’s valuation model “starting point” Is there any certainty of investment returns? Nature of exit strategy?

Value of illiquid minority interest Typically used for closely held companies

(i.e. stock transfers, gifting, or estate planning)

Uncertain returns, no market… what would you pay? Minimum Value

Maximum Value

VALUATION PREMISES & CONCLUSIONS Value Conclusions & Weighting

Methodology Value Conclusions Methodology Weighting Example

Discounted cash flow method

— $29.6 million

Public guideline company method

— $27.3 million

M&A comparable method

— $31.9 million

The following should be considered when determining the weighting of each methodology

— Strength of assumptions and accuracy assumed in the DCF

— Comparability of public guideline companies

— Accuracy and validity of private company M&A transaction data

— Volatility of the market place

— A subject company’s particular niche

— Growth profile of the subject company relative to the market

— Earnings profile of subject company relative to the market

Methodology Weighting

($000’s) Value Weighting Weighted Value

DCF $29,600 1/3 $9,768

PGC $27,100 1/3 $8,943

M&A $30,600 1/3 $10,098

Total $28,809

Understanding the ESOP Valuation Report

21

BENCHMARKING

Key Ratios

− Balance Sheet, Income Statement, Activity, Liquidity, Risk

− What percentile do you fall in

Stock Price Trends

− How do you stack up against others in your industry

− Are you beating the Dow, S&P, Nasdaq

− Great communication message if you are

Capital Structure

− How do other companies in your industry typically operate

22

BENCHMARKING RMA Comparisons

BALANCE SHEET ITEMS Current Assets as % of Assets 41.4 44.8 Cash as % of Assets 10.1 12.1 Trade Receivables as % Assets 3.1 4.6 Inventory as % of Assets 25.6 25.3 Net Fixed Assets as % of Assets 14.4 38.8 Current Liabilities - % of Assets 29.0 37.3 Long Term Debt as % of Assets 36.2 21.4 Total IB Debt as % of Assets 48.7 29.0 Net Worth as % of Assets 32.4 34.3

INCOME STATEMENT ITEMS Gross Profit as % of Sales 26.9 25.5 Operating Expense as % of Sales 26.1 24.0 Operating Profit as % of Sales 0.9 1.5 Pre-tax Income as % of Sales 0.9 1.5

ACTIVITY/OPERATING RATIOS Sales/Receivables 166.4 161.2 Days in Receivables 2.2 2.0 Cost of Sales/Inventory 14.7 15.5 Days in Inventory 25.0 24.0 Sales/Net Fixed Assets 35.7 13.2 Sales/Total Asset 5.1 4.8 Sales/Working Capital 41.4 62.1

LIQUIDITY / LEVERAGE Current Ratio 1.4 1.2 Quick Ratio 0.5 0.4 Total Liabilities/Equity 2.1 2.0

RISK Interest Coverage: EBIT/Interest 3.0 4.3 Debt Leverage: NI+ DA/Curr Debt 0.4 2.1

Balance Sheet Comparison Ratios

23

BENCHMARKING Public Company

Arden Ingles Harris Village Weis12/31/2011 9/29/2012 10/2/2012 7/28/2012 12/31/2011 Mean Median

Financial Data ($ in 000)Total Revenue 429,483 3,709,434 4,535,414 1,422,243 2,752,504 2,569,816 2,752,504Operating Income 26,122 123,177 170,978 55,552 114,280 98,022 114,280Net Income 17,005 43,444 82,512 31,445 75,584 49,998 43,444EBIT 26,370 127,374 171,565 58,123 117,606 100,208 117,606EBITDA 31,345 217,905 307,107 77,882 176,989 162,246 176,989Total Assets 135,063 1,642,109 1,952,488 409,538 1,029,004 1,033,640 1,029,004Stockholders' Equity 91,759 457,413 1,037,619 230,311 745,886 512,598 457,413

Arden Ingles Harris Village Weis9/29/2012 9/29/2012 10/2/2012 7/28/2012 9/29/2012 Mean Median

Activity RatiosSales/Receivables 98.1 61.7 85.1 144.1 48.4 87.5 85.1Inventory Turnover 16.3 9.1 10.7 26.1 8.3 14.1 10.7Sales/Net Fixed Assets 11.8 3.1 4.3 8.2 4.4 6.4 4.4Sales/Total Assets 3.0 2.2 2.3 3.6 2.5 2.7 2.5

Profitability RatiosReturn on Equity (%) 20.3 9.6 8.2 14.4 8.9 12.3 9.6Return on Assets (%) 14.2 2.6 4.2 7.9 6.4 7.1 6.4EBITDA of Revenue (%) 9.1 5.9 6.7 5.3 5.7 6.5 5.9Operating Margin (%) 6.1 3.3 3.8 3.9 4.2 4.2 3.9Net Profit Margin (%) 4.0 1.2 1.8 2.2 2.7 2.4 2.2Effective Tax Rate (%) 40.8 35.5 35.4 41.5 36.9 38.0 36.9

Liquidity/LeverageQuick Ratio 2.4 0.2 0.6 1.1 0.9 1.0 0.9Current Ratio 3.0 1.4 1.4 1.7 2.2 1.9 1.7Total Debt to Equity 0.0 1.8 0.2 0.2 NA 0.6 0.2

Growth3 Year EBIT CAGR (%) (14.8) 5.2 (7.0) 10.9 9.6 0.8 5.23 Year EBITDA CAGR (%) (13.5) 4.3 (4.1) 10.2 8.2 1.0 4.3

All GPCs

All GPCs

Public Company Comparison

24

SOURCES OF INFORMATION

Capital IQ

BizMiner

SBBI Yearbook

Duff & Phelps RPR

Industry and Trade Journals

Pratt’s Stats

RMA statement studies

Microbilt

Compensation Studies

Provided by Company

Federal Reserve

Wall Street Journal

Mergerstat Review

First Research

25

ECONOMY/INDUSTRY

What has the overall economy done and what is forecasted

− Growth

− Inflation

Industry outlook

− Developments

− Trends

Local economy

− In comparison to the national economy/global

How does your forecast relate to the above

26

ACQUISITIONS

Current multiples in either the private or public marketplace

Common metrics in the industry

Current activity

− Is consolidation prevalent right now

− Who is doing the buying

What makes a company more or less valuable

− Characteristics

Is target company above or below industry averages

27

VALUATION METHODOLOGIES

Replicate the models

What if scenarios

− Sales growth

− Expense reduction

− Impact on share price

Address any risk issues

− External Factors

− Internal Factors

Training/Communication tool

28

FINAL THOUGHTS

Valuation firm is an independent third party

− This is how they see the firm in relation to the hundreds of other firms they work with

Gives the management team/board an opportunity to look objectively at the company

Strategic decisions regarding the direction of the company can be made utilizing this information

Wealth of information contained in these reports other than the per share price

Questions?

Matthew Drake Senior Associate


Craig Olinger Financial Consultant


Documents

Understanding Valuation MDrake-COlinger