Currently, the carsales.com.au website has listed over 150,000 cars for sale from more than 2,300 dealers with thousands of private vendors. It was awarded the Frost & Sullivan 2007 online classifieds advertising advertiser satisfaction award in 2008. Moreover since November 2003, carsales has been ranked by Nielsen as the number one Auto site. This proves carsales importance and popularity amongst car buyers and sellers.
Also, with a growing trend favouring online services, the number of users who have browsed and made transactions on the carsales’ website has also increased. This can be seen from Figure 3, which illustrates the preference of private customers in using carsales.com.au relative to printing media and other internet sites from 2005 and 2009. Clearly, in comparing the two periods, the use of printed media involving the newspaper or trading post has effectively decreased from 14% to 6%. Conversely products sold on Carsales have increased from 65% to 77%.
Furthermore in the Australian market, amongst other carsales competitors, carsales is the only significant pure online competitor, with a core focus on online automotive classifieds. This can be further reinforced by Figure 4.
Government Policy
Over the years, the Government has passed through legislation of various taxes, concessions and grants on vehicles, to meet the increasing demand for motor vehicles. These policies cause shifts in the market response to motor vehicles, and play a huge role in the operation of carsales’ business.
Since 2008, both the Federal and State Governments have levied a luxury car tax on new cars priced over a certain threshold; this has increased the demand for small cars. Furthermore the State Government currently levies stamp duty and ownership of new and used cars.
Moreover the Government provides incentives in the form of concessions, grants or financial assistance. This includes the recent trade-in policy of old car to a new efficient green car, as a result more people have been searching and purchasing hybrid varieties.
Market Position and Competitive Strengths
Carsales boasts an incredible track record of strong revenue and earnings growth over the past several years. Not only do these positive results reflect great management and invest strategy, but places carsales in a leading market position. This is characterised carsales’ highly successful long-term focused business strategy. One of its core long-term business objectives is to protect and grow its unique business concomitantly enhancing carsales’ revenue. As a result Carsales has established a dominant role in its telecommunication and car industry, accepting a leadership position which builds greater barriers to entry for new competitors trying to enter the market for a share of the gains.
2.5 Production and operational strategy
Business Operations
Carsales has maintained and still continue to strengthen relationships with various groups in the automotive industry. These include automotive dealers, different portals including ninemsn, Yahoo!7 and Pentana Solutions.
③ Financial Analysis and Projections...........................
3.1 Historical and ratio analysis
Over the recent years, namely from 2007 to forecasted 2010, Carsales.com has been growing steadily but at a decreasing rate. With increasing accessibility and demand for online services, Carsales.com has the largest market share in its industry, and is predicted to continue with their success past trends.
Carsales’ is in a strong financial position. Although still a start-up firm, carsales’ has performed well above its competitors, capturing a majority of market share and has shown strong growth in operating revenue and EBITDA in the past three years; this can be visually demonstrated in Figure 7.
For more accurate comparative analysis to be performed with industry competitors, ratio analysis is more commonly used. The ratios analyses of Carsales.com in 2009 suggest that the firm is in a strong financial position as suggested by their strong profit margins and ROE, ROA and ROIC ratios.
3.2 Comparison Analysis
Through the use of relative valuation, carsales is able to be compared to other firms. With the growth of internet usage, comes the growth of the online classified industry. As carsales is an Australian automotive classifying business, this market’s has fragmented revenue across print and online participants. Carsales’ competitors are mostly larger businesses operating through both forms of media such as Carsguide owned by News Limited, Drive owned by Fairfax Media and Trading Post Auto owned by Telstra. These are three competitor hold a 35% stake in market share where as carsales has 58%. Even though these firms would be the best comparables for carsales, they cannot be used as they are subsidiaries of conglomerates.
Comparables where then selected on the basis of being listed on ASX, within the IT and Telecommunications Sector and in the sub-sector of Software and Services GIGS Industry Group. The selected firm’s market capitals were between $100 and $1,300 million and were not older than 10 years from the time of their listing.
Due to revenue growth in private online advertising and carsales’ market leading position of, it would be expected that carsales would have a stronger performance relative to comparable firms. From the ratio analysis using various revenue-based, book-based and industry specific multiples, carsales is performing well above the industry’s averages.
3.3 Discounted Cash Flow (DCF) analysis
Forecasting Financial Statements and Cash Flows
Below is a summary of forecasted balance sheet and income statement items as well as free cash flows (FCF) forecasted for the next 5 years:
(For full list of assumptions please refer to Appendix A. For full list of calculations and forecasting please refer to Appendix B)
Calculating the Enterprise Value of Carsales
In calculating the enterprise value of carsales at the end of 2009, four valuation techniques were used; net present value (NPV) method, adjusted present value (APV) method, Price-to-earnings ratio method and EV/EBIT method. Results of the four analyses are summarised in figure 7 below.
Carsales’ relatively higher valuation is justified by the fact that entrepreneurial firms are generally more optimistic about growth potential, while analysts tend to be more conservative. This is a reassuring fact for venture capitalists that are looking for trustworthy and safe investments. Further, the enterprise valuations as per ratio analyses yield a lower result than DCF methodologies. This is the case, as comparable firms lack the market share and growth of carsales, and hence have lower P/E and EV/EBIT ratios. These ratios thus undervalue carsales.
Also, in using the Price-Earnings-Ratio analysis of market comparables, the worst case, average and best case scenarios were calculated to find a range of carsales’ enterprise values:
Through P/E ratio using comparable firms analysis, a range of enterprise values was determined to be between $439.9 million and $783.4 million. The enterprise valuations as per DCF analyses above fall within the market ranges. Not surprisingly, the DCF valuations are at the upper end of the valuation spectrum as carsales’ is clearly above its peers in its industry in terms of market capitalisation and profitability.
3.4 Forecasting of future profitability and cash flows
Forecasting the firm’s profitability required significant assumptions to be made. Coming off significant annual growths in after-tax profits (21% increase) from the previous year, it was assumed that the after-tax profits would steadily grow but at a diminishing rate, while annual profitability of carsales would remain fairly constant. Such forecasts were made to reflect carsales’ strong expectations for future growth and profitability, whilst maintaining a conservative valuation.
As illustrated in the table below, carsales is a high-profit generating firm, evident in the high operating and net profit margins of 0.5 and 0.32 respectively. Empirical evidence suggests that firm’s with high profit margins usually have one or more advantages over its competition. Advantages include having greater cash flow, and the safety of having a ‘cushion’ that minimises the negative impacts of difficult financial times, which include increasing competition and unexpected changes in the online services industry. These forecasted ‘safety nets’ produce assurance for investors that are hesitant in the profitability of carsales.
3.5 Forecasting Cash Flows
Due to the success of the online services industry, carsales has displayed strong cash flows in the past few years. High revenue growth in recent years combined with relatively low operating costs contributes to high cash flows. Further, as an online service, carsales have relatively low capital expenditure and fairly stable assets and liabilities. For this reason, the steady growth in carsales’ revenue is almost fully reflected in the growth of the firm’s cash flows.
Excluding the outlier in 2011, high correlation can be seen between carsales’ revenue growth and free cash flow growth. Again, this is a positive sign for investors, as forecasted growth in revenue, will correspondingly produce high cash flows.
3.6 Capital Budgeting for the Investment Proposal
Start-up firms usually require external funding to support future growth opportunities of the firm. Accordingly, through technical analysis and consultation with the management at carsales, the optimal investment amount to fund future growth prospects was deemed to be $250 million. Although, this figure may appear arbitrary and large in some respects, with carsales’ average enterprise value of $669.58 as at 2009 (refer to table below), it would appear necessary that a large investment amount would be needed. This way, private equity investors and in particular venture capitalists will be able to obtain a reasonable ownership stake in the start-up firm.
To determine the funding requirements for carsales’ investment proposal, first the value of equity and the share price was calculated using various valuation methodologies. In summary:
To fund the investment amount of $250 million, the venture capital method is used to calculate that the number of new shares issued to venture capitalists is 59.7 million shares. The following table illustrates the capital budgeting requirements as well as venture capital ownership stakes.
In summary, $171.9 million of the investment amount $250 million will be funded by equity raising, while the remaining $78.1 million will be raised through debt financing. Although, this funding does not meet the target capital structure of a debt-equity ratio of 25%, we believe that eventually, carsales (through its positive cash flows), will be able to repay its debt, so as to reach the target capital structure.
Although only a small ownership stake of 20.50% will be attainable for venture capitalists, we believe that this is more than sufficient. The management of carsales’ are superb and thus far, are market leaders in their industry, and so a less focus can be allocated to screening and site visits. Also, with the exceptional performance of carsales’ management thus far, it would not be in their interest to diversify too much of their ownership of the firm, and would in fact potentially give rise to agency costs.
④ The Deal..........................................
4.1 Pricing and justification
For the $250 million investment proposal, venture capitalists will receive 59.7 million shares or 20.50% ownership stake of carsales.com. The share price of the convertible preferred shares held by VCs is $2.88 per share, and this value is an average of share prices derived using different valuation techniques.
The rationale for the pricing of the deal
Since carsales.com is a start-up firm, careful assumptions must be made to determine the firm’s share price. Relying on a forecasted balance sheet, income statement and cash flow analysis to determine a share price does not necessarily yield a share price that is accurate and reliable. Valuations of share prices using discounted cash flow methodologies are illustrated below through sensitivity analysis.
Net Present Value Method:
As per the net present value method (NPV) and based on a WACC of 9.975% and a terminal growth rate of 3%, the share price for carsales.com is $3.37
Although, it may appear fair that a realistic maximum price for the share price could potentially be $3.99, assuming different assumptions were used to calculate WACC, our assumptions are most accurate. Growth rates of greater than 3% are too high and often unrealistic, especially with the GDP growth rate at 3.80%
Adjusted Present Value Method:
The adjusted present value method (APV) assumes an unlevered cost of equity of 10.42%, and a terminal growth rate on tax shields and free cash flows of 3% to derive a share price of $3.37
Since valuations of start-up firms based on forecasted figures may be inaccurate due to greater uncertainty and risk of the firm, industry-based ratio analysis was performed to calculate an alternative share price. Explanations on which companies were used for comparable analysis can be found in Appendix A or B.
To find a fair share price value, the mean of the four valuation methods were taken to form a compromised share price of $2.88. A summary is shown below:
The $2.88 share price of carsales.com is an average share price valuation based on firm-specific forecasts (DCF analysis) and industry averages (ratio analysis).
4.2 Types of Securities (or contracts) and justification
There are several types of securities that can be issued to raise funds. Investments structured as collateral-attached debt are not suitable for start-up firms such as carsales. Further, as carsales is an internet company most of its assets are intangible. Since realising intangible assets is difficult and the total value of assets in 2009 was $111.2 million, the company does not own nearly enough assets to pledge as collateral for debt securities. Thus, as a start-up firm, it would be inappropriate for carsales to obtain debt financing.
A higher end of valuation was used when calculating the worth of carsales. Therefore, participating convertible preferred stock will be used to justify the higher estimate because management believes that the company’s fundamentals are not overvalued and therefore will be challenged to earn the upside of the higher valuation. This type of shareholding provides extra incentives for the founding management because the more successful the firm is, the lower the dilution is if the stock is converted by the investor. From the investor’s standpoint, participating convertible preferred stock will create a disincentive for carsales to sell the company at a price that is too low.
The stock will contain anti-dilution provisions that will adjust the conversion price down if the stock price declines or if additional equity funding is sought. In addition, the shares will convert to common stock in the event of an IPO. In case of liquidation (which includes mergers or trade sale), the investor will be able to receive the stock’s purchasing price back as well as participate on a pro-rate basis in any remaining proceeds. Also, these shares enable investors to earn a share in excess earnings. A special clause will provide the investor with the same voting rights per share as the existing holders of common stock.
Thus, the proposed equity structure has high upside potential and limits downside risk for the investor while aligning the interests of founders and investors.
4.3 Exit Strategies
⑤ Term Sheet............................................
⑥ Appendix.................................................
Appendix A - Additional Information
- Assumptions used for Valuation of carsales.com Ltd’s
- The growth rate for revenue is measured arbitrarily. The geometric average sales growth for the last 2 years (2008 and 2009) was 25.92%. However, we believe through thorough research and analysis that these high growth rates were a result of new additions to its online service, namely boatsales.com and greencarsales.com. As we do not expect new additions to its business service in the near future, we believe that the average growth rate of 25.92% is too high to use in forecasting future revenue. Thus, we use a 20.1% growth rate for the period 2010, and thereafter a declining growth rate is used. Justification for why a declining growth rate is used to forecast revenue and cash flow is explained further in Appendix B, under ‘Calculations’ tab.
- Estimated terminal growth rate of 3%. As is discussed in Appendix B, the expected GDP growth rate for Australian firms for the next 5 years is 3.80%. We assume that this will be the terminal GDP growth rate. Since we do not expect carsales.com to grow at a rate higher than expected GDP rate, we use a modest growth rate of 3% for perpetuity calculations. We use the terminal growth rate of 3% after a forecast period of 10 years.
- Income Statement:
- We forecast Revenue by using a growth rate that we determined using a declining two-stage growth method for 10 years. Thereafter, we assume that revenue grows at a terminal growth rate of 3%
- Operating expenses for 2010 is expected to grow 12% from 2009 operating expenses, as suggested by the management at carsales.com. However, thereafter, we assume that operating expenses maintains a ratio of 50.8% to revenue for the future.
- Depreciation is not calculated as a proportion to revenue. As a start-up firm, carsales is expected to make significant capital expenditures. When depreciation and capital expenditure figures are pegged to grow proportional to sales, we find that depreciation expense becomes in fact, larger than Capex. To avoid this from occurring, we grow depreciation as a ratio of capital expenditure at: Capex/Depreciation = 1.10, where a 1 unit increase in Capital Expenditure results in a 0.91 unit increase in depreciation expense.
- NOPAT or EBIT(1-T), found by using an assumed tax rate of 30%
- Interest expense was found by multiplying the cost of debt by the debt amounts in the prior year.
- As we use income statement forecasting for NPV and APV analyses, we assume that no. of shares remains constant at 231.6 million shares (despite investment funding) for valuation purposes.
- For most balance sheet items we forecasted using 2009 ratios and proportional to % changes in revenue.
- Retained Earnings was by taking the starting RE amount and adding any additions from the year. Additions from the year was any profit retained after dividends at 80% were distributed to shareholders (still assuming shares amount remains unchanged at 231.6 million shares)
- Debt items were found using an Additional Funds Needed (AFN) analysis. This analysis finds how much capital is required to support the growth in assets, which in turn supports revenue. If an AFN is positive, this means that carsales.com requires external financing, so we assume that funding is obtained through debt financing. Where 70% of debt financing comes from long term debt, and the remaining 30% from short term debt.
- In calculating Capital Expenditure (Capex) we found the change in net PPE values from the current year to the prior year, and so forth.
- In calculating Net Working Capital we the current assets: Cash, Accounts receivable and Inventories, subtracted by Accounts payable and Accruals.
- Net debt: All debt in the balance sheet + cash balance.
- Net Present Value Method (NPV):
- Assumed a risk free rate of 5.725% based on the yield of 10-year Commonwealth Government Security as at Dec 2009.
- Market Risk Premium of 5.50% found by subtracting the risk-free rate from the expected return on the Australian markets. The expected return on the Australian market based on geometric average of the Australian stock market over the last 60 years.
- Beta found by taking the weighted average betas for comparable firms within the same industry as carsales.com
- Cost of debt calculated by adding the risk-free rate with a debt premium of 0.750%. Debt premium found by applying an interest coverage ratio, as per S&P credit spread criteria. Carsales.com deemed to have an AAA rating.
- Capital Structure, found by using a compromise of the target capital structure of carsales.com’s industry and the capital structure as derived from the book values of debt and equity as at 2009. Both results yield extremely similar results, so the latter capital structure was used for WACC.
- Assumed tax rate of 30%
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Calculate WACC using the formula: wdrd(1-T)+wsrs
- Discounted the cash flow projections by the WACC
- Adjusted Present Value Method (APV)
- Value of debt (both short term and long term) used in APV analysis found using Additional Funds needed analysis (refer to Appendix B)
- Debt interests for the period found by multiplying the cost of debt (6.48%) to the value of debt in the previous period.
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The value of unlevered cost of equity found using formula: wdrd + were(L)
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Where cost of levered equity is found using CAPM: rf + B.(MRP)
- Capital structures used are based on industry target capital structure.
- We assumed that the terminal growth rates for FCFF and Tax Shields are both 3%
- Calculating the enterprise value of the firm by adding the PV of FCFF and Tax shields, assuming to be growing at a terminal growth rate of 3% after 10 years
- Ratios Analysis
- For justification on the use of P/E ratio and EV/EBIT ratio for valuation analysis please refer to Appendix B
- Comparable firms used for P/E and EV/EBIT analysis was based on market capitalisation values, beta values and the firm’s time since inception, i.e. all comparable firms have started at around the same period.
- Assume share price remains constant at 231.6 million shares despite funding that occurs post 2009. But we find the enterprise value and hence price per share, pre-funding.
- Venture Capital Method
- Calculated post-financing number of shares by first calculating the required final % ownership.
- Discounted Terminal Value found by discounting the Terminal Value as per NPV and APV analyses forecasted from 2010 onwards with the WACC and Unlevered Cost of Equity respectively.
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Investment amount of $250 million found arbitrarily. Carsales.com’s prospectus as at September 2009, seeks to raise 71.1 million x $3.50 = $248 million through equity financing. Although most of those funds will be used to repay existing shareholders, we assume that of the $250 million funds raised, most of the funds will go to support carsales.com’s growth opportunities to expand the business and further profitability.
⑦ Bibliography..................
-
Carsales.com Ltd 2009, Prospectus, Carsales.com Ltd, Australia, viewed 26 September – 7 October
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Ann Leamon et al. Venture Capital & Private Equity: A Casebook, 2008 (ed. 4) viewed 26 September – 8 October 2010
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The Reserve Bank of Australia 2010, CGS Bond Prices, Australia viewed 30 September 2010 <>
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Huntleys’ 2010, Glossary of terms.pdf, Morning Star, viewed 30 September 2010
< >
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Standard & Poor’s 2010, Estimating a synthetic rating and cost of debt, external website, viewed 30 September 2010 <>
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Aspect Huntley 2010, FinAnalysis, Australia, viewed 1 October 2010 – 7 October 2010
<>
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Wikipedia 2010, List of Countries by future GDP (nominal) estimates, [source of location unidentified] Wikimedia Foundation, Inc, viewed 1 October 2010
<>
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Jerald E. Pinto et al. Equity Asset Valuation 2010 ed. 2, CFA, USA, pg. 187-189, viewed 1 October 2010
- Gladstone, D., Gladstone, L., ‘Venture capital handbook: an entrepreneur's guide to raising venture capital’ (2002), FT Press, pg. 276, 279, 290 viewed 4 October 2010
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Sridhar, A. Participating Convertible Preferred Stock in Venture Capital Exits 2005, Financial Markets Group, pg. 2-3 viewed 5 October 2010 <
Refer to the SWOT analysis on page 8
For a full list of assumptions please refer to Appendix A
