BNFN 4304 – Financial PolicyMr. Masood AijaziCase 45: JETBLUE AIRWAYS IPO VALUATION Spring Semester 2017 – 2018Done  ByMaryam Barifah       1420023Nour Abdulaziz    1420149Balquis Mekhlafi 1420231Shrouq Al-Jaaidi       1420072Submission Date24/04/2018 Guidance SheetThis case examines the April 2002 decision of JetBlue management to price the initial public offering of JetBlue stock during one of the worst periods in airline history. The case outlines JetBlue’s innovative strategy and the associated strong financial performance over its initial two years. Students are invited to value the stock and take a position on whether the current $25–$26 per share filing range is appropriate. The case is designed to showcase corporate valuation using discounted cash flow and peer-company market multiples. The epilogue details the 67% first-day rise in JetBlue stock from the $27 offer price. With such a backdrop, students are exposed to one of the well-known finance anomalies—the IPO underpricing phenomenon—and are invited to critically discuss various proposed explanations.The case has the following learning objectives:● Review the institutional aspects of the equity issuance transaction.● Explore the costs and benefits associated with public share offerings.● Develop an appreciation for the challenges of valuing unseasoned firms.● Hone corporate valuation skills, particularly using market multiples.● Evaluate the received explanations of various finance anomalies, such as the IPO underpricing phenomenon.IntroductionJetBlue airways has been operating successfully since its inception in the year 2000. The airways company offers safety, simplicity, high craft utilization and low-fare. The company is also well-known for offering its passengers pleasant, reasonable and convenient point-to-point air travel with some special facilities. The company relied mainly on word of mouth advertising to implement its strategy. After two years of aggressive operations in 2002 and operating 24 aircrafts flying 108 flights each day to 17 destinations. The management saw it most fit to raise additional capital through the launch of public equity offering. The company’s management were preparing the requirements of the SEC to sort out the details of the offering.This case examines JetBlue management’s decision in 2002 to price the initial public offering of the airways stock during one of the worst periods in airline history. Shedding light on JetBlue’s innovative strategy and the associated strong financial performance over its initial two years. This is done through valuing the stock and taking a position on whether the current $25–$26 per share filing range is appropriate, and helping to make a recommendation according to the results.1. What are the advantages and disadvantages of going public? Why is it such a big deal? Is this a good idea for JetBlue? An initial public offering (IPO) is the first stock sale a company offers to the public, says NASDAQ. IPOs are usually issued by startup companies or small companies that are seeking equity capital and a public market. Since startups are exteremly risky, investors who purchase IPOs are usually prepared for accepting large gains for high risk. Raising additional capital was required for JetBlue to sustain the company’s growth. Advantages of Going PublicEntrance to capital markets.Going public exposes the company to financing sources while lowering the cost of c§apital, providing by that the necessary resources to further help the company grow and increase its competitiveness through adding assets to the financial statements, and improving the marketing plans. Increased liquidity.Going public allows the company’s investors to sell a percentage of their sales once the IPOs are issued. It also provides investors to increase their shares through market offerings and through sharing the risks with new shares while taking in advantage the projected increase in a company’s value. Improved credibility with stakeholders. Going public offers the company a positive impact on its stakeholders through the implementation of better managerial practices, and through obtaining better ability to recruit better incentivized employees. Furthermore, the positive impact spreads to customers and investors through highlighting the vision, values, principles and financial strengths the company has as a means of satisfying the quality standards for some customers, as well as be transparent; proving the company’s high morale. Disadvantages of Going PublicPublic scrutiny exposure.With the public exposure that the company will face once it publishes its statements, this exposes the management to governmental and public scrutiny. The company would be subject to unexpected auditing and SEC visits. They would also have to publish annual reports of their finances. This pressures investors to achieve good results and yields yearly. The disclosure of information.As companies issue IPOs, they would be going public. This means that all of their consolidated financial statements are available for the public to use. A more severe disadvantage is that competitors could use these statements to gain leverage and to plot their success around the public company’s financial statement.Exhaustion of the company’s resources and time consumption. The process of issuing IPO takes approximately 3 months, in which firms must prepare their demanded documents by SEC such as the company’s business plan, audited financial statements and projections. Moreover, the company needs to gather a reliable team that would look over the firm and it needs to develop well established relationships with stakeholders and investment bankers and other key personnel who would be involved.That being said, going public is a huge step for any company as that allows shareholders to become owners of the company. This also means that the company must have growth potential to meet the expectations of its shareholders and to maintain the position it is trying to build or have built. Going public is a step towards the right direction for JetBlue as it is a startup with potential growth. Being able to increase the capital through raising equity helps the company progress and be a potential player amongst other rivals. 2. What different approaches can be used to value JetBlue’s shares? What do you think JetBlue stock is worth? The initial prices for the stocks were determined to range from $22 to $24. The company was expecting to have a surplus in demand for their stocks, which may lead to a higher demand than the market could supply, which may result in increased prices. The arranged IPO size is 5.5 million shares, and the management wanted to increase the shares price offering to $25-$26. Most of the group predicted that the stocks would face a “blowout demand” this occurs when new stocks issued are instantly placed with investors, with no stress of issuing due to high demand. There are several schemes for pricing a stock such as dividend discount model, discounted cash flow and valuation multiples model. The management is planning to retain the profits and not distribute it; however the dividend discount model does not satisfy this approach. Moreover the other two schemes; discounted cash flow model and valuation multiples methods, will be used for the IPO shares stock price. When evaluating other low fare airlines in the domestic and international market, we will be using the recent valuations in the last valuation scheme. People may view low fare airlines with negative earnings as not suitable to use it in the evaluation, but rather they’ll consider low fare airlines with positive earnings, therefore their effect is shown through the P/E share multiple.Discounted Cash Flow Model:According to the discounted cash flow, in order to calculate the enterprise value for JetBlue we had to use the terminal value of 2010 to allow us to measure the start up value. Therefore, the enterprise value is constructed from the subtraction of all debt from the enterprise and then adding it to the cash n hand. This scheme provided us with share price of $58.92.Price/Earnings multiple: This is one of the most common formula used to determine the share’s price, and is it measures the value of the company through dividing the currnt price over earning per share. It gives us an insight comparison between the net income value and the equity value. According to exhibit 3, the EPS was $1.14. The trailing price was $19.27 and the leading price was $24.28 appear to us, via all low fare airlines in the valuation. Moreover, the prices changed when we considered only the positive low fare airlines,  To a $28.46 for the trailing price and $35.42 for the leading price. JetBlue may be mislead when using P/E valuation as it only considers the firm’s equity value, and some firms have a negative earnings per share, thus we should consider only low fare  airlines that have a positive value. However, when valuing a company through FCF, we consider more than one method such as EBIT and EBITDA rather than just P/E as they also consider the market forces; as well it gives better long term growth rates and bases.EBIT multiple:When using EBIT for valuation we take the discounted value of the forecasted 2002 period and add it to the terminal value, next we subtract the total book debt (2001) and preferred stock, last we divide the whole by shares outstanding. We used exhibit 7 for the all the multiples. The low fare airlines considered were Air Tran, America West, ATA, Frontier, Ryanair, Southwest, and WestJet. We calculated the EBIT multiple for different case scenarios (average and median of all airlines, average and median of low fare airlines, Ryanair airlines only, and Southwest airlines only.) in 2010, we calculate the terminal value by multiplying EBIT with the multiple, and for 2002 we used the formula  (EBITDA Multiple:We assumed the same scenarios as in EBIT when calculating the trailing EBITDA. We calculated the terminal value for 2010 by adding EBIT (2010) and the depreciation; next we multiplied it with the multiple. While for 2002, we used the following formula.().Multiple-Based Estimates:We deliberated the multiple based estimates by taking the leading EBIT and EBITDA multiples from the excel sheet, however, over here we did not consider the median and average of all airlines like in previous methods. As per the calculations of prices for the leading EBIT multiple, it was multiplied by the multiple of EBIT (2002), next subtracting it from the total book debt and convertible redeemable preferred stock, last we divide the whole by shares outstanding. Moreover, leading EBITDA multiple is calculated the same way as EBIT with the addition of depreciation.For the recent IPO of the trailing EBIT, considering the 3 airlines (Ryanair, EasyJet, and WestJet) we took the multiples from the book pg.626 exhibit 3, since the operating income and EBIT are significantly the same. Hence, we calculated the prices by the multiplication of EBIT (2001) with the multiple; next we subtracted the sum of book debt and convertible preferred stock and last divided the whole by shares outstanding. After determining the projected share price for JetBlue through the above schemes, we took the average of the implied share price, the leading price of the P/E (only positive earnings low-fare airlines since it is most accurate due to absence of negative numbers). For the median low fare airways, the leading share price of EBIT and EBITDA are ($58.92+$35.42+$11+$5). Therefore JetBlue is valued for $27.52. if data had a huge gap between the lowest and highest value it is most suitable to use the median than the average value and primarily the reason behind choosing the median for low fares as they have a minimum impact on the result. The terminal value of the tenth year financial forecast is considered when calculating the ninth year terminal value, therefore we used the leading multiple prices since it is based for future estimation.3. Does the financial forecast in case Exhibit 13 seem reasonable? What are the key assumptions? Is the length of the forecast period reasonable?The financial forecast in case Exhibit 13 seems to be reasonable according to the following key assumptions:v Exhibit 8, shows that Southwest and other young lows cost airlines which are comparable with aircrafts and their revenue growth. On the other hand, JetBlue forecast is higher than Southwest, in the sense that JetBlue has higher growth. After going public, the Southwest growth was rising 50% per year.v In Exhibit 1, there are calculations about the forecast of JetBlue compared with the median growth of the other low-cost airlines.v Exhibits 5 & 11, show that operating margins are progressing by they exceed the overall business margin. Moreover, the revenue, investment, and cost are inflated by 4% to 5%, this is because of the current long-term treasury bond yield (5%). Inflation will most likely be lower.v Depreciation has increase by 8 million and NOPAT is increasing by 25 million every year. In addition to this the capital expenditure is about 110 million every year and there is a decreasing trend every year. The change that is noticeable in the net working capital is approximately 30 units every year. Moreover, the earnings before interest and tax (EBIT) is another key assumption which is calculated by multiplying the revenue (sales) with a percentage of operating margin.v The low-cost strategy that appears as a strong model for the industry of JetBlue and it seems to be performing that strategy to achieve a fortunate forecast.v The nine year forecast period is reasonable but it is preferred to raise the number of years to attain JetBlue’s strategy of developing a stable level.  In Q3 in the Excel Sheet, we created a table to show the projected years of AirTran, ATA, Frontier, Ryanair and Southwest to the median of low-fare revenue and the JetBlue revenue forecast. The forecast for JetBlue’s revenue is changing from year 1 to 9 where it was 87% of revenue to 8%. This indicates that JetBlue’s revenue is decreasing. Moreover, we also forecasted JetBlue’s gross equipment from year 1 to year 9. In year 1 the gross equipment profit is $490 and at the end of year 9 it is $2,888 and that indicates that it is increasing.4. What discount rate is appropriate for the cash-flow forecast?The discount rate that is appropriate for the cash-flow forecast is the cost of capital. In excel sheet Q3 we calculated the expected returns that are correlated with investments with very similar risks. What is the most appropriate business risk is in Southwest despite of JetBlue’s having a greater total risk. Moreover, Exhibit 5 has the capital structure, beta and tax rate that are related to Southwest. The calculations that are provided in Q3 shows that the cost of debt which will reflect the probability of inflation of the cash flow forecast in the long term, where the preferred cost of debt is 8.7%. CAPM (Capital Asset Pricing Model) is used to estimate the cost of equity based on the market-risk premium (5%) and risk-free rate (5%) in the long-term treasuries. Therefore, the estimated cost of capital (WACC) is 9.74% for Southwest.   5. What was your approach for terminal value? How do your terminal-value assumptions affect the estimated value of JetBlue shares? Discounted Cash Flow Model is the fundamental method for valuation which is used to estimate the desirability of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projection and discounts them using the weighted average cost of capital (WACC) to arrive at a present value, which will be used to assess the potential investment. Thus, in order for us to discount the future cash flows, we must first calculate the WACC; which is minimum required rate of return that an investor will expect to receive when investing money in the firm. The required information regarding JetBlue’s WACC calculation is not available in the case, so it was not accessible for us it to calculate. Therefore, to calculate the cost of debt for a private company like JetBlue, an analysis of comparable companies’ cost of debt is used. So, in order of getting an appropriate valuation, we must depend on terminal value assumptions. To estimate terminal value, comparable multiples will be used. In the Excel Sheet Q2 & 5 determine the terminal value estimates using different multiples and growth models. Moreover, by using the WACC (9.74%) that was calculated in question 4, the cash flows will be as follows.    ● The first step to take, is that earnings before interest and tax (EBIT), net operating profit after tax (NOPAT), depreciation and capital expenditure (CAPEX) should all be taken directly from Exhibit 13.● Second step, change in the net working capital (NWC) was calculated by taking the numbers from Exhibit 13 and then subtracting the old year from the most recent year. For example, 2002 change in NWC is (63.5-33.9) = 29.6 which is approximately 30 and the rest will be done for every year till 2010. ● Free cash flows for all years from 2002 till 2010 are calculated by using the following formula (NOPAT + Depreciation – CAPEX – Change in NWC).● WACC, weighted average cost of capital which is discount rate was taken directly from Q4 in the Excel sheet. ● To calculate present value of cash flows, we took the free cash flow of the particular year divided by (1+WACC) ^n.● Then to calculate the discounted value of the forecasted period, we used the sum function by adding all the present value of cash flows. ● Book debt for 2001 was taken from Exhibit 2 in the book which was calculated as follows (Short term borrowings +Current maturities of long term debt +long term debt) which is equal to (28.781+54.985+290.665) = $374 million.● Convertible redeemable preferred stock and book equity value for 2001 were both directly taken from Exhibit 2.● To calculate the total capital for the year 2002, we added 2001 book debt, convertible preferred stock, book equity, capital expenditure and change in net working capital and then subtracted the depreciation. As for the rest of the years, we took the previous year’s total capital and add to it CAPEX and change in NWC and subtract the depreciation.●  Shares outstanding is 40.6 million shares where 35.1million shares was taken from the footnotes, and that is added to the 5.5 million shares planned for the IPO. Both numbers were taken directly from the book. ● In order to calculate the terminal value, two methods can be used: 1) the Perpetuity Growth Model, which assumes that the free cash flow (FCF) will grow at the same rate to infinity (forever). This usually gives us a higher terminal value than the exit multiple model (EMM). 2) The Exit Multiple Model (EMM) on the other hand estimates the cash flow using multiple earnings. Where the price to earning (P/E) ratio, EBIT, and EBITDA are commonly used approaches to calculate terminal value.● For the terminal values estimate, we first started with the constant growth model which tends to be low. Typically, the perpetuity growth rate is between the historical inflation rate of 2%-3% and the historical gross domestic product (GDP) growth rate of 4%-5%. Therefore, we used two growth rates, one at 3% and the other at 5%. The perpetual growth method that is used to calculate the terminal value formula is considered the preferred method as it assumes the business will continue to generate free cash flow (FCF) at a normalized state forever (perpetuity). ● When the growth rate is 3%, the price is $6, and when the rate is 5%, the price is $23. We first calculated the terminal value (TV) for 2010 by using the following formula: TV = (FCFn x (1 + g)) / (WACC – g).  To calculate the TV for 2002, we took the 2010 terminal value divided by 1 plus the WACC to the power of 9 (indicating the 9 years from 2002 and 2010).● The rest of the calculations are analyzed more in question 2 above. The Terminal Value using the EBITDA and EBIT multiples can be found in the Excel sheet Q2&5.What need to be done first, when using the constant-growth model, we can observe that if JetBlue is going to shift a steady growth in the year 2001, then the stock is not worth that much. This further suggests that using a constant-growth model method for planning period will probably be too short to value JetBlue. Therefore, it will be better to calculate the terminal values based on EBIT and EBITDA multiples as both will create a broader estimate range. Calculating the multiples based on the average of the industry has concerns such as the effects of outliers that lead to misleading figures and the lack of truly comparable companies to base the calculations on. As it can be seen in Q2&5 in the attached excel sheet under the trailing EBIT and EBITDA multiples that taking the average or median of all airlines decreases the terminal value as this took the outliers into consideration. While when taking the average or median for the low fare airlines (which are more closely comparable to JetBlue as it is considered a low fare airline itself) the terminal value increases. We get even better terminal value estimations and reasonable valuations when just using the Ryanair’s multiple to get the terminal value as it serves as good comparable to JetBlue, since the cash flows for JetBlue are best compared to Ryanair. JetBlue’s terminal value multiple should increase in 2010, also it will increase its growth that are currently for Ryanair. Moreover, we assume that JetBlue will become as Southwest that has an effective terminal value. Based on the leading EBIT multiple of Ryanair valuation shows that there shares price is $61 whereas Southwest share price is $22. This shows that the Southwest airlines price is considered low and incomparable as it does not have the same progress in growth that JetBlue has over the coming years. For the trailing EBIT multiple for the recent initial public offering (IPO) in Q2&5 in the excel sheet, we took the three airlines (Ryanair, EasyJet, and WestJet) were the multiples were directly taken from the book in page 619. The 2001 EBIT is taken from page 626 in Exhibit 3. As operating income (loss) is the same as earnings before interest and taxes (EBIT). Moreover, the prices were calculated by multiplying the 2001 EBIT with the multiple then subtracting the sum of book debt and convertible preferred stock and all divided by the shares outstanding.  In addition, JetBlue’s terminal value indicates that its stock price must be higher than the initial public offering (IPO) price. Therefore, according to the terminal value, the estimated value of the stock is undervalued. 6. What are the pros and cons of using a comparable-multiple approach in valuation?Pros:1. Since the market is based on public data, it is a reflection of the market’s overall growth and risks. 2. It could be easily measured and compared against other firms. This is greatly beneficial when a company is unstable. 3. It is quick and convenient. 4. It is usually updated on a regular basis as it is based on market data. This is good at having a glimpse of how the market is doing.5. It uses lesser assumptions that what the DCF uses.6. Easy to communicate to different players in the market.7. Determines a benchmark value for the multiples used in the valuation8. It does not require forecasts but other methods use forecasts such as valuation multiples use present date.Cons:1. Since the valuation is market based, it is subject to misevaluation as valuation can be skewed during severe share prices fluctuation.2. It could be hard to identify relevant markets especially if the company is operating in a niche market.3. The valuation that is based on a company’s forecasted cash flows is different than the one of existing market conditions.4. The company may face issues as the valuation of targets is solely dependent on other firms’ valuation. This would not really serve the purpose of a SWOT and risks search.5. Subjective choice of multiples. 6. It is subject to distortions and could be considered negative.7. It does not make assumptions that serve the long-term profitability and growth potential. 8. It is extremely sensitive to revenues and expenses which must be updated regularly. If a company has its unique revenue recognition means, it could mislead the profit multiplier significantly.7. At what price would you recommend that JetBlue offer its shares? Per the analysis made we recommend a share price of $27.52. it was calculated through the average of our stock prices appearing in the excel sheet. It is the most suitable price that declares the firm’s value at the offering time and can achieve a thriving offering that the firm wants to approach. Moreover, it can aid in raising the funds needed for the expansion.Conclusion and RecommendationsThe co-lead manager, Morgan Stanley had initially calculated a price range for JetBlue shares of $22 to $24. Yet, with the sizeable excess demand for the 5.5 million shares being offered they were debating on increasing the price of the shares or keeping them as it was originally. By analyzing the financials of JetBlue’s and after the examination of the comparable multiples and discounted cash flows, we recommend to take an average as JetBlue’s share price (58.92+35.42+ 11+5)/4= $27.52. This is to avoid leaving too much cash on table, and insuring the initial public offering (IPO’s) success, and most importantly management receiving funds needed for their business expansion.  References