HBS BOSTON BEER

For terminal growth rate, we assumed it will fall into a range of 6.5% to 7.5%. We don’t believe that it will continue its momentum of strong growth after the year of 2000. It will slow down tremendously since entire beer industry is not experiencing much growth.

The tax is computed by taking the average of tax over earning after interest over the past 5 years. Excise tax, cost of goods sold, SGA and administrative and general expense are all expressed as a percentage of sales. The assumptions used for forecasting 1996 to 2000 expenses are average figures of the past 4 years. Using an average number allows us to eliminate any outliers may exist in any specific year.  On the other hand, we used 1995’s percentage of sales number of each expense and used it to annualize the accounts from September 30 to December 31. This is because these accounts are all involved in the chain process of generating sales. For example, by investing into advertise expense, we may gain more sales through this marketing campaign. For the rest of 1995, we believe strategies for generating sales are relatively the same and therefore should continue the trend until the year end. For the other years, we cannot correctly predict how strategy will change with an unpredictable market, so we assume how each dollar invested into these expense have generated revenue over the past year and using it to forecast the future.

We took the average of days in accounts receivable, inventories and account payable of past 3 years. Presuming strategies for managing these accounts will not change, we can successfully forecast these accounts based on these assumptions. And finally, for depreciation, we choose to depreciate the existing asset another 4 years. This is because we cannot find any information for each specific asset on the existing account and assuming these assets have been depreciating for a few years. Furthermore, for the 7 million dollar assets that we are going to acquire using the proceeds, we will use a useful life of 7 years to value its depreciation over the years. This number is calculated by taking the average of 3 and 10 which are the range of useful life for most of the assets used in this industry. It is not the best estimate, but based on our knowledge and information given, we believe it is a reasonable assumption.

For APV valuation, the total long-term debt is $1,900,000 in 1995 and it will continue to be paid off by Boston Beer Company, with interest accruing at 11.5%. During year 1995 to 2000, Boston Beer Company will not borrow additional debt. In addition, we also assumed that the future debt will have the same Terminal Growth Rate as company sales, since the company will borrow more debt as the size of the company expands. Though the total debt is continuously being paid off, its long-term trend is upward sloped.

Question 2

To value Boston Beer Company using comparable companies, we have decided to look at two companies that are in the same industry as BBC and have recently gone public: Pete’s Brewery Company and Redhook Ale Brewery.

Operation Structure

Both Pete’s and BBC are contract brewers which allow them to take advantage from larger brewers’ excess capacity. Low transportation cost and overhead cost has always been the competitive advantages for contract brewers; at the same time, both companies have invested intensively in marketing and promotion.

Unlike BBC and Pete’s Brewing Company, Redhook Ale Brewery owned and operated its own breweries. In addition, Redhook also established a strategic alliance with the biggest brewery company, Anheuser-Busch. Redhook is selling its beer through A-B’s powerful distribution network instead of investing in marketing and promotions.

Obviously, Redhook and BBC have positioned themselves differently in the craft beer industry. Therefore, out of the two companies in craft beer industry that have gone public, we believe Pete’s Brewery Company will be a better comparable for BBC valuation than Redhook.

Value-Drivers

Due to consumers’ sophisticated tastes, specialty beers are much more welcomed than before. The craft beer industry has been growing intensively since 1990. BBC and Pete’s have experienced compound annual sales growth rate of 109% and 57%, respectively.

We believe the value-driver for contract brewers are mainly brand identification and product quality. Both Pete’s and BBC have invested intensively in marketing and product distribution. These two factors have directly contributed to the increase in Net Sales for Pete’s and BBC. In addition, because contract brewing have greater manufacturing flexibility, it allows companies to incur lower capital and overhead cost, hence higher gross margin.

We have computed the following representative ratio of value to value-drivers for the both Pete’s Brewing Company and Redhook Ale Brewery:

We have adjusted both P/E and P/B ratios respect to IPO price. Since P/B was originally calculated using shareholder’s equity as of September 30, 1995. P/E was calculated based on P/B and annualized 3rd quarter ROEs which are 129.3% and 8.6% for Pete’s Brewing and Redhook, respectively.

The adjusted P/E and P/B ratios turnout to be smaller than P/E and P/B dated on 11/20/1995, which is reasonable because IPO prices was much lower than the stock prices on 11/20/1995.

The Enterprise values for Boston Beer Company calculated using above multiples are list below:

From the table above, the enterprise value has a range from $418 million to $839 million. We believe the major value driver for both Boston Beer Company and Pete’s Brewing is Sales; therefore, we decided to use EV/Net Sales and EV/Gross Profit as our major valuation multiples. The EV for Boston Beer Company is approximately $430,280.185.

When we use multiple valuations, we have assumed that the capital structure for Pete’s and BBC is the same, which is reasonable because they are both contract brewers. They don’t have their own brewery and their operation margins are similar.

One potential problem arises after Pete’s gone public is change in its operating strategy. After Pete’s went public, company has invested all the IPO proceeds in constructing its own brewery in California. The capital structure for Pete’s could change due to this major investing in capital.

Question 3

Based on the enterprise values computed using DCF, APV and comparable multiples, we can calculate the IPO price by subtracting the total long-term debt from the enterprise value and dividing this difference by the number of common shares to be outstanding after initial public offering. A total long-term debt of $1,900,000 can be found from the long-term debt schedule in Exhibit 5 of the case, and the number of common shares to be outstanding after initial public offering on the first page of Exhibit 5 (Case) is 19,182,119. Consequently, the IPO prices determined by DCF, APV and comparable multiples are $13.41, $11.51(in base scenario) and $22.43, respectively.

DCF makes too many skeptical assumptions that are difficult to confirm. First, the terminal growth rate is hard to estimate, because the forecast growth rate of 31% from 1996 to 2000 is unlikely to sustain, so the assumption that the perpetual growth rate will be 7.0% is largely by faith. Second, the capital structure of the company may not be consistent indefinitely, as a reduction of 10% in D/E ratio from 1994 to 1995 is evident. Several forecast accounting items are based on assumptions as well. Lastly, the beta comes from an educated guess, so the cost of equity used in WACC may not be accurate. APV shares many common assumptions as the DCF, such as the terminal growth rate and beta, but it is not sensitive to changing capital structure. Comparable multiples have the advantage of using companies from the same industry that just went public as benchmarks. However, Pete’s Brewing Company and Redhook Ale Brewery differ from Boston Beer Company in sales size, growth rate, and strategy. Boston Beer Company’s annual sales exceed the other two by a large margin, and the growth rates of the three companies have significant differences. From a strategic standpoint, Redhook Ale Brewery has its own production line, Boston Beer Company insist on remaining a contract brewing, and Pete’s Brewing Company plans to use the proceeds from its recent IPO to construct a brewery of its own. Moreover, craft beer industry itself relies on proprietary recipe as a sales strength, which differs among different companies. On top of that, too few available comparable companies may result in an estimate that is not very reliable, as only Pete’s Brewing Company is used as a comparable company. Since using multiples is too sensitive to unique events and only one comparable company is available, DCF and APV will be more reliable methods to determine the IPO price than comparable multiples valuations. Moreover, APV is more flexible than both DCF and multiples and it can value BBC more precisely, because it doesn’t have the D/E constraint. APV can be used to valuate company that have unstable D/E over time, which in this case is suitable for valuating Boston Beer Company. Therefore the IPO price should be set in the range of $7.53 to $21.69 for Boston Beer Company.

Question 4

The craft beer industry as a whole is overpriced, because the current rapid growth is not sustainable and numerous competitors are emerging.

The growth assumptions made by analysts may be wrong, so investors may mistakenly believe that the craft beer industry may continue fast growth for the next five years. The craft beer industry is considered correctly priced at high P/E multiple only if the craft beer industry as a whole can experience such high growth rate for a long time, as in the early 1990s. However, the growth forecast contains a number of forward looking statements and may not be true. Also, the growth rate of 40% in craft beer industry is very unlikely to be sustainable indefinitely. The beer industry as a whole had experienced a stagnant growth of 0.1% from 1991-1995, and analysts predicted no growth in future. If the industry as a whole is experiencing zero growth, growth of one firm actually means contraction of another firm. We see no evidence from this case that craft beer industry is superior or has competitive advantage over major producers or second tier producers in long term. For instance, major and second tier player has more financial resource available. It will be very hard for small firms to grab away the customers from large firms in long term. Just like a zero-sum game, the growth may finally disappear and the market reaches saturation. The market may be too optimistic for the future of the craft beer industry.

Also, the market beliefs fail to consider the factors of competition. The rapid growth of existing craft beer companies spurred the founding of over 600 specialty beer companies. Since so many competitors emerged in such industries, it is possible that the competitors may compete away the profits in future, making the industry as a whole unattractive, dragging down the price or raising the cost. This potential risk may be and indicator that the industry is overpriced.