FIL 440 Financial Management

Framework for Case Analysis The sample analysis of the Is Reggie Redbird Crazy? stock valuation case is meant to provide some very general guidelines for the details of case analysis throughout FIL 440. It should be noted that each case has its own individual issues to address. Therefore, the format and outline of the issues presented in the sample report are specific to the Reggie Redbird case. However, when performing your own written case analysis, here are some specific items to include: 1. An executive summary, approximately 1 page. You can think of the executive summary as an abstract of the entire report. The executive summary provides readers with enough detail to capture the essence of your report in only one page. The intended audience is for readers who do not have time to read the entire report. You can assume that the reader is familiar with the case, so you do not have to duplicate case details in the executive summary. Instead, focus on how your analysis and your conclusion from that analysis. NOTE: There will be some duplication in the executive summary from the full case analysis, but remember that the reader of the executive summary wont see the duplication since they dont have time to read the rest of the report! 2. Analysis of major issue(s). What is the problem (or problems) that must be dealt with? What is the decision that needs to be made? What options are available to the main character(s)/company? In some cases, the key issues are explicitly stated in the case. In fact, there may be specific questions that require analysis. In other cases, youll have to imply the main concerns from the case context. As you will see, the timing of the cases will coincide with the previous (or current) weeks topic(s). In addition, the week before the written analysis is due, we will hint at the major issues developed in the case and discuss any concerns you have about information provided. Please read the case before coming to class along some basic thoughts on the major issues. When you write up your case analysis, be sure to state the specific assumptions that underlie your analysis and be sure to defend your assumptions, if possible. Is your assumption based on data given in the case? How reliable is that data? Is there other information provided in the case that makes you question the managers assumptions? (As an example, in the stock valuation case, I assumed that the DDM is reasonable. This has implicit assumptions about the rate of growth of ESC. I also used CAPM to estimate risk this means assumptions about the risk-free rate, etc, though CAPM inputs were given in the case.) 3. Sensitivity analysis (time pending). Try different assumptions (if possible) to understand the robustness of your conclusions. Do you reach different conclusions under different assumptions? What is the sensitivity of your assumptions? (For example, in the stock valuation case, the stock price was VERY sensitive to changes in the growth rate and the required rate of return.

After recognizing the importance of this assumption, I suggested that the case may be solved by reviewing the reasonableness of approximately 9.5% growth for ESCs dividends. My conclusion partially based on history, ESC appears very capable of growing at that rate.) 4. Impact of nonfinancial issues on decisions. Does the financial decision involve other non-financial assumptions? Does the financial decision impact other parts of the firm? Does other parts of the firm impact the financial decision? Is there other information that you would like to have about the company? The point of this section is to recognize that financial decisions do not take place outside of the scope of the rest of the company. These nonfinancial issues may vary widely. 5. Conclusion. Summarize your findings and recommend a decision that is clearly supported from your analysis.

NOTES TO THE WRITTEN ANALYSIS: Everything in your report should directly support your conclusion. You may have looked at many things in your analysis, but in the end, if it didnt have any impact on the final decision, it shouldnt be included in the report. There is no need to repeat details from the case. You should assume that the reader of your report is familiar with the issues the case. Therefore, your report can focus on analysis and calculations with only very minor references to the case. Limit your analysis to no more than ten written pages, double spaced. These pages can be supported by additional exhibits (calculations/spreadsheets/graphs). On rare occasions, additional readings may be necessary. If you use other sources, please include them in your write up.

IS REGGIE REDBIRD CRAZY? STOCK VALUATION CASE ANALYSIS

STOCK VALUATION CASE Executive Summary ISU has made a bid for the remaining portion of ESC stock that includes a 24% premium over the current ESC stock price of $34. This report reviews the offer initiated by Reggie Redbird. The details of this report include: Valuation of ESC stock. This report attempts to determine a range of appropriate stock prices for ESC. Using the Gordon dividend discount model, along with

historical dividend information and projections by Value Line, we estimate the value of ESC stock in the range of $35 to $50. When reviewing historical growth rates in ESC dividends, the 9.50% growth rate implied by the current offer of $42 appears attainable. Review of Reggie Redbirds investment record. While our analysis lends credence to the bid price of $42 per share for ESC, we also examine the historical record of Reggie Redbird. Mr. Redbirds historical investment success may add to

shareholders comfort of the current bid for ESC, as his historical returns are remarkable when compared to broader market results. Mr. Redbirds investment philosophy. Letters to shareholders gives us a unique look at Mr. Redbirds considerations for investing. While there are some issues that seems unusual, it is hard to argue with the Mr. Redbirds investment results. Other issues. Mr. Redbirds position on ESCs board of directors may shed light on the amount of information Mr. Redbird had about the future prospects of ESC. Based on our analysis, there appears to be support for a higher price for ESC. Value Lines publication shows that the offer price is reasonable and historical growth rates

may provide good reason to be optimistic. Therefore, the offer appears to be a good investment for ISU.

1. INTRODUCTION ESC Corp. currently sells for $34. The bid price of $42 per share represents a 24% premium over the existing share price. This report attempts to evaluate the offer made by Reggie Redbird. This report is organized as follows. First, we develop our own estimate of ESCs stock using the dividend discount model and available information. Our

valuation boils down to determining the best growth rate to assume for future dividends. Next, we review supporting evidence on Mr. Redbirds historical record for investing. Here, we assess whether ISU has a habit of making investment mistakes in the past. Finally, we review the investment philosophy of Reggie Redbird in an attempt to glean more information about his potential investment success. Based on all the evidence, we then conclude. 2. ESC VALUATION We look at the value of ESC shares in two separate ways: 1. Reaction of ISU share price 2. Dividend discounting techniques Market Reaction If the bid price of $42 was perceived as too high, any excess price would be at the detriment of the shareholders of ISU. We would expect the market to react negatively to the announcement, dropping the share price. But in fact, the market value of ISU increases $180 million after the announcement. This reaction includes two components:

(1) the increase in value of ESC shares already owned by ISU (17 million shares) and (2) the additional value of buying ESC at only $42 per share. Since ISU already owns some shares, part of the market reaction would include the reassessment of ESCs value: Gain due to existing shares = 17 mil * (42-34)=$136 million The remaining increase in value for ISU (180 mil 136 mil = 44 mil) represents added value given that the company has paid only $42 per share: 44 mil = 34 mil * (P-42.00) P=$43.29 Judging from the market reaction, it appears that ISU shareholders agree with Reggie Redbird's offer. In fact, they appear to be implying that the $42 bid was a good deal.

Value Line Projections Instead of implying prices from market reactions, we can perform our own analysis to estimate the current stock price (P0). The valuation of any security is the present value of expected cash flows. For stocks, the expected cash flows are dividends and the projected future sales price. We assume that the discount rate can be derived using the capital asset pricing model:
rs rf rm rf

From Exhibit 2 in the case, we estimate the required return on ESC stock as:
rs 6.50 % 0.75 5.50 % 10 .63 %

We recognize that there may be other ways to estimate the market capitalization rate for ESC, but we are given no other information in the case. For the rest of our analysis, we

assume the risk-adjusted discount rate for the cash flows from ESCs stock will be 10.63%, as estimated above. For the first estimate of the stock price, we discount the estimates of future dividends and stock prices from Value Line. The top of Exhibit 1 (attached) shows the calculations from discounting the Value Line estimates. Under the low projections, the current stock price is estimated as $35.17; under the higher projection, would the current value is $49.57. Thus, the offer price of $42 appears right inline with the (publicly available) information available in the Value Line Investment Survey. It is also

interesting to note that even under the low projection of Value Line, the current market price of $34 seems low.

Dividend discount model valuation The Gordon model makes several assumptions about the valuation of stock. The stock price (P0) is the present value of expected cash flows (dividends) Dividends grow at a constant rate g In order to calculate the value of ESC stock using the dividend discount model, we need an estimate of the first dividend, the growth rate in dividend, and the discount rate. One of the more difficult assumptions is the future growth rate. The bottom of Exhibit 1 and Exhibit 2 (attached) provides several looks at the growth rate and its use in the Gordon model. The bottom of Exhibit 1 uses the Value Line Information to derive the implied growth rate in two ways. First, one can estimate the projected growth rate of dividends

forecasted over the next four years. For example, the compound growth rate under the lower projection can be determined by:
0.76 (1 g ) 4 0.58 g (low ) 6.99 %

Under the high projection, the implied growth rate in dividends is 14.87%. A second growth rate is implied in the terminal value of the stock forecasted by Value Line. If Value Line uses the Gordon model to estimate the stock price at the end of the year 2013, we can rearrange the model to imply what Value Line used for long-term future growth.

P2013 g
Thus, under the low projection:
g 10.63%

D2014 rs g D2014 P2013

rs

0.76 (1 0.0699) 54.21

9.13%

Under the high projection, the implied long-term future growth is also 9.13%, indicating that long-term prospects of ESC are similar under the two different Value Line projections. For another estimate of the growth rate, we can see what is implied by the current market price.
g rs D1 P0 10 .63 % 0.58 34 .00 8.92 %

At this point, we have several indications of future growth near 9%. It seems reasonable than if ISU is going to offer a premium over the existing stock price of the $34, it may be that Reggie Redbird is projecting higher growth than is anticipated by the market or

Value Line. Exhibit 2 (attached) shows the historical dividends of ESC. Given the sharp increase in 2008 dividends, we perform two growth rate calculations: one including and one excluding the year 2008. Regardless of the time frame, ESCs historical increase in dividends has been much higher 9%. While it is clear that strong growth cannot continue indefinitely, Mr. Redbirds offer for the remaining shares of ESC may indicate that he strongly believes that growth rates will be higher than 9%, at least for the next few years. To see this, we imply what growth rate is needed over the long-term to justify the offer price of $42. If we assume that the first dividend is the same as last years $0.50 per share:
g 10.63% 0.50 42.00 9.25%

This value shows that even if the dividend doesnt change next year, if future dividends grow by only 9.25%, this would justify a stock price of $42 today. Note that this growth rate is only slightly different from the long-term Value Line projections. The calculation also shows how sensitive the DDM is to small changes in the growth rate as highlighted in the following table: Projected growth rate (g) D1= $0.58 and rs=10.63% 8.8% 9.2% 31.78 40.70 Stock Value

9.6% 56.59

We conclude that the implied growth rate of 9.25% from Mr. Redbirds offer seems reasonable based on historical performance and Value Lines projections.

3. MR. REDBIRDS HISTORICAL RECORD Our analysis suggests that Mr. Redbirds offer price seems reasonable despite the large premium. We also consider the historical record of Mr. Redbird to determine if he has a habit of overpaying for his investments. His record may also help interpret the positive market reaction to the ESC announcement. We consider first the overall experience of ISU, which is (very, very loosely) a holding company for investments of Reggie Redbird. If Mr. Redbird has had a good track record, we would expect ISUs shareholders to respond positively. In 1976, the price of ISU was $12 and in 2008, the price was a whopping $18,933, implying a compound annual growth rate of 37.7% over the 23 year period.

18,933 (1 g ) 23 12 g 37.7%
In comparison, the growth rate of the S&P 500 over the same period was 10.0%. The historical growth rate of ISU provides shocking evidence of Mr. Redbird's formidable investment performance. The acquisition of Stephens & Jacobs provides for an analysis of a single investment decision. Using information about the dividends provided in the case, we can calculate a rate of return of using an internal rate of return methodology (see Exhibit 3). The internal rate of return (IRR) determines the compound annual return on an investment after accounting for intermittent cash flows. ISU paid $295 million for

Stephens & Jacobs in 2000; since then, theyve received significant dividends. We would like to know what rate of return this $295 million has earned. To determine the

IRR, we need to find the discount rate that equates the present value of all of these cash flows with the price paid.

295

100 (1 IRR)1

35 (1 IRR) 2 60 (1 IRR) 6

40 (1 IRR) 3 70 (1 IRR) 7

45 (1 IRR) 4 75 (1 IRR) 8

50 (1 IRR) 5 80 (1 IRR) 9

Ignoring any dividends after 2008, we find the IRR is 14.5%, which exceed the markets return over the same period. However, this ignores all future dividends of Stephens & Jacobs. We can estimate future dividends by calculating a terminal value, assuming that 2008s dividend will continue forever. The present value of this perpetuity of $80 million, discounting at ISUs cost of capital of 11.73% (using CAPM) is $682 million. When included in the 2008 cash flow, this increases the IRR on the Stephens & Jacobs investment to a whopping 25.7%. Finally, to gain even further insight into Mr. Redbirds history, we can also look at the specific experience of owning ESC. In 1991, Mr. Redbird paid $11.4 million for 17 million shares of ESC. In Exhibit 4, we review the cash flows earned (dividends) from investing in ESC stock. The final cash flow would also include the current market value ($34) of the shares already owned by ISU. The exhibit shows that ESC has been a very profitable investment for ISU shareholders.

4. OTHER ISSUES Earlier in the report, we saw that ISU's shareholders reaction as they revised the value of ESC stock from $34 to $42. Such a dramatic reassessment may be explained by Mr. Redbird's position on the board of directors at ESC. The bid by Mr. Redbird may

reveal that he possessed inside information about the companys future growth as a result of his position. The bid represented a signal to the market of a more optimistic outlook than was originally held. In effect, this may have biased outside investors to tilt more toward the high Value Line projections. Clearly there may be significant issues related to a change in ownership of a company. But the announcement of the purchase suggests that there will be neither major changes in the operations of ESC nor any specific economies of scale with existing insurance operations owned by ISU. We conclude that little or no resentment stemming from ownership changes and no effect on future stock performance.

5. MR. REDBIRDS INVESTMENT PHILOSOPHY The letter to shareholders explaining Mr. Redbird's investment philosophy may provide further insight into Mr. Redbirds historical record or more specifically help interpret the offer for ESC. Mr. Redbirds philosophy has many similar themes to modern financial theory. He talks about the shortfalls of GAAP accounting, the importance of time value money, and the importance of incremental cash flow valuation. However, Mr. Redbird suggests three elements of modern finance which he believes to be false. 1. Risk adjusted discount rates. Rather than adjusting the discount rate to reflect the risk of investment cash flows, Mr. Redbird appears to use a risk free rate for valuation purposes. He supposes that with careful analysis, the cash flows can be predicted with a high degree of accuracy. We interpret this belief as a blatant disregard of risk. The mere fact that he suggests that using the risk-free rate when cash flows are more

certain implicitly recognizing the relationship between risk and return. The result of ignoring risk adjustments are that valuations may be too high, since the present value of projected cash flows is discounted at a lower rate. Using risk adjustments may lower the initial investment in many assets. While Mr. Redbirds record is undeniable, we questioned whether the record might have been even more favorable if Mr. Redbird used risk-adjusted discount rates. 2. The benefits of portfolio diversification. Mr. Redbird abhors diversification when he says "Diversification is a defensive strategy for uninformed investors." While Mr. Redbird shuns the benefits of portfolio diversification, the holdings of ISU actually indicate that he practices diversification more than he preaches. Exhibit 1 in the case provides information about major investments and segment earnings. The holdings indicate a wide range of products including insurance, retail clothing, publishing, and consumer goods. These seemingly unrelated investments would appear to provide significant diversification benefits. 3. Stock market efficiency. Mr. Redbird mocks universities which advocate market efficiency. Mr. Redbird disagrees that available stock prices are fair predictors of the true value of companies. He believes there is tremendous opportunity for actively pursuing higher returns and diligent research before investment. However, market efficiency theory suggests that passive portfolio management (simply investing in a broad stock market index) is as good as any investor can do. Taken together, we believe that Reggie Redbird has tremendous faith in his investment process. But the contradictions to modern finance (mentioned above) imply that when he invests, he has a tremendous informational advantage. If he does has an informational

advantage, this may imply that that markets may still be efficient, he is simply benefiting from insider information. While we believe that informational advantages can help in the short-term, we felt skeptical extrapolating these benefits too far. However, as the

historical experience in the previous section illustrates, we also find it difficult to argue with the confidence that Reggie Redbird attributes to his philosophy.

Conclusion The 24% premium included in the offer for ESC stock may, at first, seem high. However, our analysis supports the offer of $42 per share. Using Value Line projections, our estimate of the stock price is between $35 and $50. In order to justify the offer, the future growth rate of ESC must be approximately 9.25%. Given recent history and projections by Value Line, this growth rate appears quite attainable. Also, Mr. Redbirds current insider position at ESC and his tremendous track record lend more confidence to the offer. If we were a shareholder in ISU, we would approve this purchase and

anticipate strong future returns from the acquisition.