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Inflating Value (A)1 Jack, a confident and outgoing undergraduate student, had just accepted a summer internship as an analyst at a prestigious investment bank in New York. Jack was an outspoken student in the classroom, never afraid to voice his opinion among his classmates and professors. He was enjoying his internship so far, as this was the career he had wanted to pursue since deciding to focus his undergraduate studies on finance. He had heard stories of the lifestyle of investment banking - completing deals during the day before enjoying the city's finest nightlife in the evening. However, the pace and sense of urgency appeared even more demanding than he had anticipated. And, as he sat at his desk only several weeks into his internship, he realized that in some ways he felt intimidated by the culture of the investment bank. The office in which Jack was working could be described as the opposite of flat. It was very clear where individuals were on the food chain, if not by the way people spoke to each other, then by office size and/or their wardrobe. There appeared to be an unwritten rule that one could never dress better than anyone at a level above them. Aggressive cutaway collars and French cufflinks were reserved for those above the analyst and, in most cases, the associate level. Jack had noticed this strict hierarchy from the second he walked into the office on his first day. As he sat in the \"bullpen\" with countless analysts surrounding him, Jack was called into his Associate's office. As he walked to the meeting with his Associate, he was very aware of the culture and office norms. Jack also knew that in investment banking there is a very strict 1 Developed by Jessica McManus Warnell, University of Notre Dame, with Karen Whelan-Berry, Providence College This case was inspired by an actual internship experience but names and other situational details have been changed, and interview sources left un-credited with permission, for confidentiality and teaching purposes. This material is part of the Giving Voice to Values curriculum collection (www.GivingVoiceToValues.org). The Aspen Institute was founding partner, along with the Yale School of Management, and incubator for Giving Voice to Values (GVV). Now Funded by Babson College. Do not alter or distribute without permission. Mary C. Gentile, 2010 1 hierarchy of command. The managing directors are the most senior bankers who maintain and establish relationships with clients, most of which are huge corporations. Next, are the vice presidents, who typically will lead a particular deal that a managing director passes off to them once he or she secures the business from the client. While a managing director is always on a deal team, the vice president leads its execution within the office. Along with the vice president on a given deal, there is typically an associate and an analyst. \"How's it going, Jack? Why don't you take a seat? I want to loop you in on an exciting deal that I just got staffed on. It's a client of Peter Fisher's and we are also going to be working with Michael Parsons on this one,\" said David, Jack's Associate. Jack was excited that he had been staffed on a deal team with Fisher, one of the best managing directors in the office, because it was a great opportunity to make a good first impression with him. The associate continued, \"So the company we are representing, ABC Lighting, is a manufacturer and marketer of light bulbs of a variety of sizes. Not only do they produce the light bulbs, they also produce the fixtures related to lighting. ABC is looking at opportunities to sell. Given the current economic climate, it has run into some trouble. It originates a lot of its business from new construction and with that market completely bottoming out; its growth projections in the immediate future are not stellar. Additionally, it employs non-LED technology, which is to some extent out of date technology because it is not as energy efficient and just does not produce the same quality of light. What we need you to do, Jack, is to tackle some of the initial analysis. We need you to tell us what this thing is worth, what we can sell it for. Let's focus on comparable multiples analysis taking a look at these companies as its peer group.\" David rattled off 15 lighting company names as Jack frantically scribbled the names on a notepad. He was pleased that his research as an intern would be contributing to such a significant decision at the company. \"Perfect,\" Jack responded, \"I'll take a look at this right away.\" As Jack left his associate's office and headed back to his desk, he knew he needed to do a good job on this deal. After all, he had only been there for three weeks and this was his first staffing on a live deal. As he dove into the analysis, Jack was carefully, but quickly gathering the information on ABC's peer group. In this sort of analysis, the analyst will look at the stock trading prices for each comparable company and compare it to some operating metric for that company. For example, if a company is trading at a stock price of $10 per share, and has projected earnings for the next year of $1.00 per share , the company would be trading at a 10 times multiple. As Jack went through the analysis, he realized that the majority of the companies within the peer group which the associate had identified were trading at roughly 13 times earnings per share. Applying this average multiple of 13 times earnings to ABC's projected earnings of $1.50 per share, Jack calculated the appropriate share price for ABC at around $19.50. With 15 million shares outstanding, ABC's equity value and selling price was just under $300 million. Before Jack reported his findings to his associate, he took a deeper look at some of the companies that were in the peer group to assure that they were truly comparable companies. What Jack found, however, was that none of the companies in the peer group made the light fixtures, only lights. Furthermore, the majority of the comparable companies were actually This material is part of the Giving Voice to Values curriculum collection (www.GivingVoiceToValues.org). The Aspen Institute was founding partner, along with the Yale School of Management, and incubator for Giving Voice to Values (GVV). Now Funded by Babson College. Do not alter or distribute without permission. Mary C. Gentile, 2010 2 producers of LED lighting rather than the non-LED lighting which ABC produced. These findings materially changed the valuation Jack had just completed. Jack went back and repeated the analysis with a peer group he felt was more appropriate, with companies that made both non-LED and LED lighting and a variety of light fixtures. He found that this peer group actually traded at only 6 times earnings per share on average, reflecting the poorer growth opportunities currently present for that segment of the lighting industry. A six times earnings multiple applied to ABC's earnings of $1.50 resulted in a value of $135 million dollars, or $9.00 per share times the 15 million shares outstanding. If Jack didn't say anything, the valuation would be much higher. The greater the valuation, the happier the client and, in turn, the larger the fees the bank would earn. The larger the fee the managing director brings in to the firm, the greater the director's bonus, and as a result, the greater the bonuses for those bankers who helped the director bring in and complete the deals. Should Jack voice his opinion regarding the companies that should make up the peer group for ABC? Jack sat in the bullpen with his fellow analysts around him frantically cranking out valuations for other deals for other associates, and Jack realized he had a decision to make. The difference between not voicing his opinion and doing so was selling the firm for about $300 million or less than half that much, $135 million. Jack wanted to do the right thing for the investment bank, for ABC, and for his career. As Jack considered his options, he reflected upon how he had spoken out his entire educational life. This thought gave him the confidence to realize that he was doing the right thing if he spoke up about the valuation, but he was still very aware that he was trying to make a good impression to receive a full time offer after graduation. He didn't want to step on any toes but, at the same time, Jack was not comfortable turning over the original peer group and valuation work, which he felt was off by more than $150 million dollars. What should Jack say and to whom should he voice his opinion? How should he present his discomfort with the original peer group and valuation at around double what he believed the company was truly worth? Rev. 8/29/2012 This material is part of the Giving Voice to Values curriculum collection (www.GivingVoiceToValues.org). The Aspen Institute was founding partner, along with the Yale School of Management, and incubator for Giving Voice to Values (GVV). Now Funded by Babson College. Do not alter or distribute without permission. Mary C. Gentile, 2010 3
