Bosten Beer Case Study
IPO Pricing for Boston Beer Company Inc.
We address the following key questions regarding Boston Beer Company (BBC) to explore the issues surrounding its Initial Public Offering. First of all, we determine the fair value of BBC to be $211 million based on a DCF valuation of projected future cash flows and explain our key assumptions and potential problems arising from those assumptions. Second, we find BBC’s fair value to be $314 million by relative valuation and discuss how differences in operating strategies might translate into differences in financial ratios. Third, we determine BBC’s IPO price to be $15 per share. Finally, we look at the craft brewer industry as a whole and we find that it may be overvalued by the market.
PART I: DCF Valuation
In our intrinsic valuation approach, Boston Beer Company’s future free cash flows of the next ten years are projected in the spreadsheet. Present value of the company at the end of 1995 is calculated by discounting ten year’s free cash flows and terminal value by weighted average cost of capital. As we can see from the spreadsheet, the company fair value is $210.78 million. Subtracting the debt level of $1.95 million, the equity value is therefore $208.83 million.
Appendix 1 includes the full valuation model we used. The key assumptions we made and the calculation methods we used are listed as follows:
BBC’s annual sales growth rates from 1992 to 1994 are 63.55%, 60.14% and 48.84% respectively. The unaudited income statement suggests that sales growth may slow down further. Hence, although the market growth is positive in the near future, it is expected that BBC’s net sales will slow down and eventually reach a “mature stage”, where the company maintains GDP growth rate going forward. In our financial projection, we assume that BBC’s sales growth will decline linearly from 45% to 5% in ten years and enter “mature stage” afterwards. The growth rates in net sales for the next ten years (including 1995) are therefore projected as: 45%, 41%, 37%, 33%, 29%, 25%, 21%, 17%, 13% and 9%. After ten years, the growth rate will remain steady at around 5%, which is the sum of real GDP growth rate at that time (2.5%) and the inflation rate of 2.8%.
In the past five years, cost of goods sold as a percentage of net sales has been quite steady. We used an average rate of 44.7%. Gross profit is then estimated as 55.3% of net sales.
We believe it is also reasonable to assume that advertising, promotional and selling expenses are proportional to net sales since BBC has been adopting an intensive sales and marketing strategy to build up its market. The same linear variable assumption applies to general and administrative expenses because the company will have to continuously recruit employees and increase management efforts to sustain the sales growth. Therefore, we combine those expenses into one category -- total operating expense. Although individual expenses may vary in different years, the overall operating expense rate tends to be steady over years. In the last three years, on average, total operating expenses accounted for 48.1% of net sales. Other income/expense (net) is insignificant in size (less than 0.1%) and therefore left out in our financial projection.
Although the company as a partnership was not subject to income taxes, it will be taxed after public offering. We believe pro forma income is a more precise measure of value in a forward-looking perspective. For the past five years, the pro forma tax rate for the company is 42% on average.
Free Cash Flows were calculated as FCF=EBIT*(1-Tax) +Depreciation/Amortization - Increase in Working Capital - Capital Expenditures.
Depreciation and Amortization cost is assumed to be a variable cost proportional to net sales. The average depreciation and amortization cost is 0.7% of net sales from 1992 to 1994. Capital expenditures includes the replacement and addition to capital assets and should be proportional to depreciation and amortization cost. Using data from the past three years, capital expenditures are estimated as 230% of Depreciation and Amortization, or 1.61% of net sales. Change in Working Capital can vary significantly over years in the case of BBC and is estimated by the weighted average rate of change from Dec 1992 to Sept 1995, which comes out to 0.57% of net sales.
With all the free cash flow for the next ten years in place, discount factors are needed in order to calculate present value. BBC’s weighted average cost of capital is used as the discount factor and is calculated as KWACC = (Equity/Value) × KE + (Debt/Value) × KD× (1-Tax)
We assume that the book value of debt equals the market value of debt. As of Sept 30, 1995, short and long term debt totaled $1,950 thousand. Cost of Debt (KD) for BBC is 11.5% with semiannual payments. Compounding it gives an annual rate of KD = (1+11.5%/2)2 = 11.83%.
Partners’ Equity totaled $29,517 thousand, after adjusting for the recapitalization and receipt of estimated net proceeds of the Offering ($12.5 per share) as suggested in case Exhibit 5.
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Cost of Equity can be estimated by the CAPM model: E (Ri) =Rf+βi (E (Rm)-Rf). Expected market return, Rm for the US in 1995 was estimated by the US 20-year historical average annual return up to 1994, which is 14.60% using S&P 500 as benchmark Index. The risk free rate is considered the rate of long-term government bonds. In BBC’s case, the government 30-year Treasury notes’ annual rate of 6.26% was applied.
Unlevered Beta for BBC should be close to unlevered beta for Anheuser Busch, as they both operate in the same industry. In 1994 Anheuser Busch had a levered beta of 1.0. According to their annual report, it’s debt had a market value of $3,270 million (assuming market value equals book value). Its shareholder’s equity was $4,434 million in book value. With an average P/B ratio of 29.69/7.22=4.11, its market value of equity is therefore $18,224 million. Anheuser Busch’s tax rate is 39.5%. Adjusted for capital structure, the unlevered beta of Anheuser Busch and BBC was 0.902:
Therefore the levered beta for BBC is calculated to be 0.937 and its cost of equity was 14.07%. The Weighted Average Cost of Capital for BBC is 13.62%.
We used the perpetuity growth method to compute the terminal value of the company 10 years from now as FCFn*(1+g)/(r-g)= 32,428*(1+5%)/(13.62%-5%)= $395 million.
There are several possible drawbacks in our projection model. Firstly, we predict that the growth rate in net sales declines linearly over time and after ten years, it will remain constant at 5%. Although our projection makes practical sense that a growing company cannot grow at high rate forever and will eventually grow at the pace of economy. However, the time frame (10 years as we projected) and the growth curve (linearity as we projected) can vary significantly. Hence, our projection model may not be accurate. Secondly, we practically assume that all costs are variable cost because we do not have further information on cost structure. There must be a portion of “fixed cost” within the various expenses and depreciation/amortization cost. In this sense, our approach will tend to overestimate the cost and underestimate the value of the company. Lastly, due to insufficient information we were not able to use exit multiple method to determine terminal value. Instead, we used the perpetuity growth method, whose accuracy relies on assumptions regarding perpetuity growth rate and consistent future WACC. The 5% perpetuity growth rate we assumed is not rock-solid assumption as the long-term economic growth rate may change over time. In general, DCF valuation requires making a number of assumptions. We have made assumptions that we felt were most reasonable, but that does not indicate that our valuation is perfect. Without comparison with other firms and consideration of the market sentiment and prevailing market conditions, the DCF valuation is only inward-looking and lacks external perspective.
PART II: Relative Valuation
Using relative valuation, we found the fair value of Boston Beer Company to be worth $314 million as of year end, 1995.
To arrive at this value, we first sought out comparable public firms for BBC. Because Pete’s Brewing Company and Redhook Ale Brewery are two other players in the USA Craft Beer industry, we determined that they were good comparables for BBC. While Pete’s value-generation strategy and asset structure are more similar to BBC, with less physical production assets and more investment in sales and brand marketing, its growth rate is enormous in comparison, so it would make sense to use a growth-adjusted multiple when using Pete to help us value BBC. On the other hand, Redhook’s growth rate is lower than that of BBC. Further differences stem from its small size and its heavy investment in internal production facilities. Nonetheless, Redhook is BBC’s competitor and its equity value reflects the market sentiments in the craft beer industry, so it is useful as another benchmark when valuing BBC.
While we have some financial data for Pete’s, they are only given for Sept 30, 1995, before Pete’s IPO. Thus these numbers do not give indication of Pete’s fair value. What we do know are Pete’s post-IPO P/E ratio and sales volume growth rate and thus, we can find a fairly good PEG multiple for Pete’s. We can do the same for Redhook, and we found that the resulting numbers fall in a small range. Pete’s PEG was 0.9 while Redhook’s PEG was 0.88. Since these values are already so close to one another, we simply assumed an average and used 0.89 as the PEG of BBC. Multiplying this value against BBC’s growth results in a P/E ratio of 50. Multiplying that against BBC’s total expected earnings for 1995 gives us an approximate 1995 year end equity value of $312 million.
It is important to note some assumptions we have made up until this point. To find the PEG multiple, the average compound annual growth rate for the 4 years spanning 1990 to 1994 were used. Since we have not yet reached year end of 1995, we could not use 1995 data. In addition, these growth rates are derived from growth in barrel volume of sales for each company, since these numbers go back further in time than dollar sales. We chose to use an average growth rate rather than the most recent year’s growth rate to eliminate potential errors coming from market short-term fluctuations, we decided that a 4-year growth rate would be a more reliable indicator of firms’ growth rates as of November 20, 1995 and beyond.
We’d like to note that although we used forecasted declining growth for BBC when we performed the DCF valuation, declining growth difficult to adjust for in terms of valuation multiples. And since the DCF assumes that BBC will mature in the foreseeable future, it is not unreasonable to assume the same for Pete’s and Redhook as well. After all, they cannot grow forever. If we allow that BBC’s declining growth rate corresponds with the craft beer market’s eventual maturity then it will not be necessary to standardize growth decline in the comps we use.
Another assumption was made with respect to the timing and amount of earnings. Although the PEG ratio is calculated as of November 20, 1995, we assume that it would not change significantly until year end, 1995. We also projected that BBC’s 1995 earnings would total $6.3 million by year end, which is a linear scaling of the firm’s $4.7 million earnings from the first three quarters of the year. We assumed the firm would make 1/3 of this amount in the last quarter of 1995. Since the $4.7 million itself is unaudited, there may be some error in using it, and that error could be magnified by our extrapolation, but we believe that our assumption was fair in the absence of other predictive information.
To justify our choice of using the PEG multiple, we argue that it is simple, yet holds information about the vital dimensions of comparison. We believe that the value drivers of the craft beer industry are earnings, sales, growth potential, and for Pete’s and BBC, perhaps it is also investment in branding and sales staff. The following table shows several other multiples we considered, and their drawbacks.
Having established a fair value of BBC’s equity at $312 million, we then added the market value of liabilities to find the total firm value of BBC. The total value of debt for BBC is $1.95 million, as reflected in its adjusted summary financials for Sept. 30, 1995 and in Note G. of the financial statements. As a result, the fair value of BBC comes out to $314 million.
While relative valuation is generally simpler and sometimes even more accurate than a DCF analysis, it also has limitations. The greatest constraint is finding comparable firms. In our case there were only two firms with available financial information, and even then the information was packaged and assumptions were non-transparent, so that was a serious limitation. A decent relative valuation requires at least five or more comparable firms. In our case, we only had Pete’s. While Redhook operated in the same industry, it was very different from BBC in terms of asset and cost structure, and growth strategy. We used Redhook to add more perspective to our comparison, because relative valuation using only one comparable company is severely lacking.
However, even given perfect information, there will never be a firm that is exactly the same as the firm being valued. Using the PEG multiple, we have adjusted for various differences such as size of earnings and growth rate, and we were lucky to find a firm – Pete’s – that is quite similar to BBC in terms of its operational, production and marketing strategies and expenditure patterns. However, there are still differences such as effects of leverage, which were not addressed. There is also the inherent assumption that traded companies are always fairly priced by the market, which does not always hold. If investors are overly optimistic about the craft beer industry, Pete’s and Redhook may both be overpriced. If we benchmark BBC to these firms, BBC could also potentially be overvalued. However, as the case suggests, IPO watchers are beginning to worry that the levels of growth seen in the craft brewer industry are unsustainable. In this case we do not believe that investors are not optimistic beyond reason.
PART III: IPO Price
From the discounted cash flow analysis in question one, we determined the total market value of equity to be $208.83 million. The fully diluted total number of shares outstanding after the IPO was calculated to be 20,813,379 shares. Thus, dividing the market value by the total shares outstanding, the implied IPO stock price is $10.03. On the other hand, the total market value of equity from the public comparables analysis was determined to be $312 million. Dividing it by the number of diluted shares, the IPO price is calculated to be $15.
Given our results, we find that $15 is the most reasonable IPO price for Boston Beer Company.
We believe that the $10.03 stock price which resulted from the DCF analysis is too low. DCF valuation uses a purely inwardly-looking financial model and does not fully take into account the competition, industry outlook, and investor sentiment. It simply uses an estimated growth rate, which was assumed to be declining linearly over ten years and eventually remain at a growth rate of 5%. However, the growth curve and the eventual growth rate may be extremely different from the projection. The growth rate may end up being much higher than 5% because of the fast growing industry – the investors in this industry will likely be able to predict it much better than we can in our DCF. Also, we assumed that the majority of BBC's costs were variable with sales revenue, in order to simplify our model. However, the company must have incurred some fixed cost every year to run its business units, so this assumption will have overestimated our costs and underestimated our free cash flows and equity value. As a result, there is a much greater chance that the DCF analysis undervalued BBC than overvalued it.
On the other hand, the equity value and the share price derived from the relative valuation are already adjusted to reflect the market sentiments and existing market conditions in the craft beer industry. This is extremely important since it takes into account external market factors not intrinsic to the firm but which have implications on the firm’s value.
Moreover, we can see that after Pete and Redhook went IPO, their share prices jumped up significantly on the first day of trading. Pete’s increased by 40% while Redhook’s increased by almost 60%. This shows that the investors are very optimistic about the craft beer industry, and that even though the firms were offering at a price which they deemed fair, the investors priced the shares much higher. Typically, a firm will price its IPO at 85% of the value it believes it is worth, to ensure a price at which there will be market clearance. However, this does not explain the 40% and 60% increases in price experienced by firms going public in the craft beer industry. Given that investors are optimistic, both of our valuations may have potentially underpriced BBC’s IPO. Comparing the two IPO prices we found, we hold that the higher $15 resulting from relative valuation is a more reasonable offering price for the company than the very low, $10.03 DCF price.
When it comes to the pricing of an equity offer, the management of the company will tend to have different incentives than the investment bank. In order to maximize the proceeds from the offer, firms like BBC will want to take advantage of investor optimism and price the IPO as high as possible to ensure no money is left on the table. Meanwhile, the investment bank, who has a commitment to sell the shares, will generally underprice the IPO for fear that the market will not clear and the shares will lose value. We believe that the $15 IPO share price is sufficiently priced to generate the desired amount of capital for BBC (in their offering prospectus BBC has assumed that a $12.50 IPO price would raise adequate capital). We also believe this price should invite market clearance. Considering Pete’s and Redhook’s experience with IPO, we foresee BBC’s shares jumping on the first day of trading due to optimism and investor flipping. The price increase will bring in interest for BBC.
PART IV: Pricing in the Craft Beer Industry
We believe that the craft beer industry as a whole is overpriced by the market. The reasons are as follows.
First, the U.S. economy appeared to be doing particularly well in the 1990s and it was called “long boom”. Investor sentiments tended to be strong and positive towards the manufacturing industries, including the craft beer industry, in this bullish economic environment. Several Wall Street analysts forecast that sales volume of the craft beer segment could triple in five years. Others believed that the segment could grow even more. Since stock price can be largely affected by the market confidence, we believe that the positive market sentiment overheated the stock price.
Secondly, it is quite doubtful that the annual growth rate of sales in the craft beer industry could sustain at 40% in the next decade. The “big 3” brewing companies, which dominated 77% of domestic market5, could easily threaten the sustainability of this growth rate. If these large companies lowered price or enhanced marketing force to step up competition, the current marketing programs used by relatively small companies in the craft beer segment might not be sufficient to resist the fierce competition. As a result, the annual growth rate would drop significantly. In this sense, we believe that the market was overly optimistic about the growth of the craft beer industry. We should take into account the uncertainty caused by the rivalry among incumbents.
It is difficult for investors and analysts to “accurately” value a stock or an industry based on pro forma analysis, because people rely on a lot of assumptions and predictions which may not be accurate. Thus, many external market factors can cause uncertainties and disturb the valuation. For example, the change in consumer preference from mass-produced beers to craft beers heated up the craft beer industry and the market tended to overestimate the increased demand for craft beers. Therefore, the projected sales volume could also be overestimated, which led to an inaccurate valuation.
Moreover, the craft beer companies’ sales strategy also played a role in altering the “real” price. BBC offered 990,000 of the shares directly to consumers through coupons attached to six-packs. Using the coupon, the consumers could obtain shares at a lower price than its IPO price. That offering was fully subscribed. Apparently this sales strategy created a link between beer consumption and equity investment, and it attracted lots of consumers, no matter it was for the purpose of beer consumption or purely investment or both. Not even to mention how many beer lovers supported the craft beer companies by investing in the equity. The psychological factors behind this could alter the way investors perceived and valued the stocks and the industry.
Another possible reason is that if the benchmark or comparable company was already overpriced, the valuation of the company preparing for IPO would be overpriced as well. This error could happen one after the other. In that sense, the whole industry could be overpriced.
In summary, the craft beer industry was overpriced due to lots of internal and external factors, even psychological factors could influence investor sentiments and obscure the way people evaluate stocks and industry and make investment decisions.
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Average compound annual growth rate of volume sales is calculated as:
Growth = (1+ % 4 year Cumulative Volume Sales Growth from 1990 to 1994)1/4 -1
= (1+ (1994 Volume Sales/1990 Volume Sales -1)) 1/4 -1
Example: for BBC,
Growth = (1+ (714 barrels/121 barrels -1)) 1/4 -1
= (1+ 490%))) 1/4 -1
Source: Real growth rate: http: //www.indexmundi.com/united_states/gdp_real_growth_rate. html; Inflation rate: http://www.usinflationcalculator.com/inflation/historical-inflation-rates/
Source: Standard &Poor’s , extracted Jan 30, 2011
Source: http://sec.edgar-online.com/anheuser-busch-companies-inc/10-k405-annual-report-regulation-s-k-item-405/1998/03/25/section3.aspx, extracted Jan30, 2011
Unlevered beta =Levered beta/[1+(1-Tax)*(D/E)]=1.0/[1+(1-0.395)*(3,270/18,224)] =0.902
Levered beta = unlevered beta*[1+(1-Tax)*(D/E)] =0.902*[1+(1-0.42)*(1950/29517)] =0.937
Cost of equity for BBC, KE = Rf+βi (E (Rm)-Rf)=6.26%+0.937*(14.60%-6.26%) =14.07%.
KWACC =29,517/(29,517+1,950)*14.07%+1950/(29,517+1,950)*11.83%*(1-42%) = 13.62%
This is calculated as 2,540,379 new shares offered + 18,273,000 fully diluted share outstanding as of Sept. 30, 1995.
Source: The Boston Beer Company, Inc Case