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ROSETTA STONE: pricing the 2009 IPO

Teaching Note
This case examines the April 2009 decision of Rosetta Stone management
to price the initial public offering of Rosetta Stone stock during one of the
most difficult periods in capital-raising history. The case outlines Rosetta
Stones unique language-learning strategy and its associated strong
financial performance. Students are invited to value the stock and take a
position on whether the current $15 to $17 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 40% first-day rise in Rosetta Stone stock from the $18 offer
price. With this backdrop, students are exposed to a well-known finance
anomalythe IPO underpricing phenomenonand are invited to critically
discuss various proposed explanations.
The case provides opportunities for the instructor to develop any of the
following teaching 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.
Study Questions
1. What are the advantages and disadvantages of Rosetta Stone going
public?

2. What do you think the current market price is for Rosetta Stone shares?
Justify your valuation on a discounted-cash-flow basis and a market
multiples basis.
3. At what price would you recommend that Rosetta Stone shares be sold?
Supplementary Material
Although the context of the discussion is mergers, the Darden technical
note Methods of Valuation for Mergers and Acquisitions (UVA-F-1274)
reviews the mechanics of firm valuation using discounted cash flow and
comparable multiples. This teaching note may be assigned as reference
material for the valuation analysis required in this case.
Supplementary video in support of this case is available from the Darden
Publishing channel on YouTube by using the links provided in the case.
There are three video exhibits available for the instructors use:
Video Exhibit TN1. Epilogue 1 is a designed for use at the end of class as a
synopsis of the pricing decision or as an introduction to a discussion on the
IPO underpricing phenomenon. It features interviews with Tom Adams,
CEO, Rosetta Stone, Inc. and Phil Clough, Managing General Partner, ABS
Capital Partners.
http://www.youtube.com/watch?v=3sViTF2AgxU
Video Exhibit TN2. Epilogue 2 is a short clip of Tom Adams, CEO of
Rosetta Stone, discussing the industry classification of Rosetta Stone.
http://www.youtube.com/watch?v=jPx3dNmoyR8
Video Exhibit TN3. Epilogue 3 is a designed for use at the end of class to
summarize the stock price history for Rosetta Stones first year of trading.
http://www.youtube.com/watch?v=1rdx2n3zNVc
Teaching Plan
1. What is going on at Rosetta Stone?

The opening question is designed to allow students to put up the relevant


background of the important managerial decisions facing Rosetta Stone
management. In particular, the discussion should focus on the decision to
go public and the price at which Rosetta Stone shares should be sold.
2. Tell me about the economics of the Rosetta Stone business. Is this a
business that you expect will generate interest among investors?
This question invites students to explore the Rosetta Stone business
model, its competitive strengths, and its potential to sustain a strong growth
and profitability trajectory. Case Exhibit 6 can be a useful exhibit in
highlighting the financial performance of the business. Typically students
agree that Rosetta Stone is a very interesting business with strong potential
for investors to participate in attractive financial upside potential.
3. What do you think the current market price is for Rosetta Stone shares?
Poll the class for their best-guess estimates of the market price of Rosetta
Stone shares. Ask for an explanation for the variation in estimates. Draw
out the observation that there is a substantial amount of uncertainty with
valuing start-up businesses. The variation in class estimates is likely due to
differences in judgment across thefd class as well as some possible
technical errors in the valuations. Emphasize that, although there are no
doubt many sound estimates, there are also substantial opportunities for
error. An important objective of the discussion is to identify the sources of
variation. Briefly review on the board the different parameters used by
representative students in a discounted cash flow-based and a market
multiples-based valuation.
4. The market-multiples approach seems easy. What are the pros and cons
of using a market-multiples approach in valuation?
Have one of the students highlight the mechanics of a multiples-based
valuation. For example, a simple valuation using K12, Inc. as a comparable
would be as follows:
Rosetta Stone EBITDA 2008 [case Exh. 7] | $ 34.6 million |
K12 Inc. EV/EBITDA ratio 2008 [case Exh. 10] | 13.4 times |

Implied Rosetta Stone enterprise value | $463.6 million |(34.6x13.4)


Current Rosetta Stone debt [case Exh. 7] | $9.9 million |
Implied equity value | $453.7 million |(Equity-Debt)
Prior to offering shares outstanding [case Exh. 9] | 17.2 million |
Implied share price | $ 26.38/share | (453.7/17.2)
The instructor may elicit a discussion of the pros and cons of the marketmultiples approach to valuation. The class may raise the following points:
Pros of multiples
* Convenient and simple
* Reflects what the market is willing to pay for a comparable firm
* Helpful when firm is not in steady state and future uncertain
Cons of multiples
* Ignores need to make explicit assumptions regarding long-term
profitability and growth
* Subject to market misevaluation; a relative (rather than absolute)
valuation measure
* Subject to accounting distortions
* May have difficulty in identifying comparable firms
* Meaningless if financial numbers (e.g., EBITDA) are negative
* Financial numbers in denominator may be more cyclical than valuation in
numerator

The instructor may flesh out these points in greater detail. Some
perspective on important principles worthy of consideration by the financial
analyst is detailed below.
In sampling industry comparables, we want to include only those firm
valuations that are comparable to the business of interest. If the profits for a
comparable firm are expected to grow at a higher rate, the valuation or
capitalization of those profits will occur at a higher level because investors
anticipate higher future profits and consequently bid up the value of the
respective capital. There is much here to discuss in the case of Rosetta
Stone. One important debate surrounds whether the business is a software
business or an education business. The outcome of this decision maintains
large valuation effects.
One might consider other multiples of observable quantities for valuation
purposes. One common multiple is the earnings or P/E multiple. This
multiple compares the value of the equity with the value of the net income.
In a free cash flow-valuation model, earnings multiples are inappropriate for
use because they value only the equity portion and assume a certain
capital structure. The market-to-book ratio faces similar concerns. Common
multiples appropriate for free cash flow valuation include EBITDA (earnings
before interest, tax, depreciation, and amortization), EBIT, and total capital
multiples. In this case, we have a particular challenge with the P/E ratios:
The majority of the estimates are negative.
The instructor can explore the advantages and disadvantages of using
EBIT, EBITDA, or total capital ratios as terminal-value estimators. The
choice of multiple metric depends on the comparability of the value
relationships between firms used to provide the estimate and the valuation
firm. For example, EBITDA is more appropriate for capital-intensive firms,
where the depreciation-expense relationships differ between the valuation
firm and its peers. Although commonly used, the earnings (P/E) and book
equity (market-to-book) ratios may be inappropriate if the leverage differs
across comparable firms. These approaches are also inconsistent with free
cash flow-based terminal-value calculations. Lastly, the negative net
earnings common to this industry in 2001 create an additional challenge to
P/E-based valuation.

Although a multiples-based valuation approach provides a convenient,


market-based approach for valuing businesses, there are several reasons
to proceed with caution. The simplicity of multiples can be deceptive.
Multiples should provide an alternative way to triangulate toward an
appropriate long-term growth rate, not a way to avoid thinking about the
long-term economics of a business. Market multiples are subject to
distortions due to market misvaluations and accounting policy. Accounting
numbers farther down in the income statement (like net earnings) are
subject to greater distortion than items higher up in the income statement.
Because market valuations tend to be less affected by business cycles
than are annual profit figures, multiples can exhibit some business-cycle
effects. Negative multiples based on negative profits are difficult to use.
Last, identifying suitable comparable firms is essential but challenging.
Multiples can be computed with different timing conventions. A trailing EBIT
multiple for December 2001, for example, uses the December 2001 firm
value divided by the 2001 EBIT. In contrast, a leading 2001 EBIT multiple is
computed as the December 2001 firm value divided by the expected 2002
EBIT. Leading and trailing multiples can also be computed using figures
from the next or most recent quarters. Leading and lagged multiples will be
systematically different for growing businesses. When using multiples for
valuation purposes, it is important to be consistent. If a trailing multiple is
used, the end of Year 9 terminal value must be computed using the Year 9
financial forecast; if a leading multiple is used, the end of Year 9 terminal
value must be computed using the Year 10 financial forecast.
5. Lets look at a discounted cash flow-model approach to valuing Rosetta
Stone. Is everyone comfortable with the financial forecast in case Exhibit
7? What are the key assumptions? Is the length of the forecast period
reasonable?
The case Exhibit 8 forecast is based on the following important
assumptions:
1. Revenue growth declining from 53% in 2008 to 5% in 2018.
2. EBIT margin declining from 14% in 2008 to 7.5% in 2018, including a
large R&D expense rate to maintain innovation in the business.

3. An overall proportional increase in asset investment with revenue


increases.
The revenue projection typically generates the most discussion. Some
students will argue that 20% to 35% growth rates are unreasonable (as
suggested by some analysts); other students will make the case that
Rosetta Stone has a demonstrated track record of growth and maintains
large capacity for global expansion.
One important concern that should be raised is the length of the planning
period. Ten years may be too short to fully develop the Rosetta Stone
strategy to a steady-state level, where growth slows to that of the general
economy and economic profits are normal.
6. What discount rate is appropriate for the cash-flow forecast?
Because Rosetta Stone is not yet public, estimates for a market-based
discount rate must be based on the expected returns associated with
investments of similar risk. In calculating a discount rate, some parameters
are straightforward. (The risk free rates are available in case Exhibit 4.) The
cost of debt and marginal tax rate are mentioned in the case as 7.5% and
38%, respectively. The market risk premium is detailed in the case as 6.5%
over long-term government yields or 8.5% over short-term government
yields. Based on the industry comparables, leverage is lightly used among
peer companies. The cost of debt should play a minor role in a weighted
average cost of capital calculation. (CAPM beta estimates are available in
case Exhibit 9.) However, the students face a challenge in identifying an
appropriate set of comparable firms. A discussion can ensue regarding the
nature of Rosetta Stone risk and how investors might consider matching on
risk profile. Depending on the comparables chosen, reasonable discount
rate estimates may vary from 7% to 13%. In the base case valuation used
in this note, we use 10% as the discount rate.
7. What was your approach for terminal value? How do your terminal value
assumptions affect the estimated value of Rosetta Stone shares?

The instructor can emphasize that the terminal value estimate plays an
important role in a company valuation. The instructor can canvass the class
for techniques for estimating terminal value.
Exhibit TN1 illustrates a constant growth-model approach to terminal value
estimation. In this approach, we estimate a steady-state cash flow in 2019.
This cash flow assumes that the income statement and the balance sheet
grow at a steady-state growth rate of 4%. To do this, we grow the NOPAT,
net working capital, and net PPE lines at the steady-state growth rate. The
steady-state cash flow is equal to the 2019 NOPAT less the investment in
net working capital and net PPE. The 4% rate is set based on an
expectation of 2% real growth and 2% expected inflation (based on the
3.8% 30-year Treasury yield less an assumed real rate of interest of 1.8%).
The terminal value is estimated using the perpetuity formula, with the value
at time 0 equal to cash flow at time 1 divided by the difference in the
discount rate and the constant growth rate. The terminal value in 2018 is
estimated to be $972 million.
Given that EBITDA in 2018 is estimated to be $110 million (EBIT of $106.6
million plus depreciation of $3.4 million), the $972 million terminal value
implies an enterprise value-to-EBITDA ratio of 8.8 times. Such a multiple
seems reasonable when reconciled with the mature comparables in case
Exhibit 9. It is worth noting that only the mature industry comparables are
appropriate to benchmark Rosetta Stone in the steady-state year. Using the
market multiple of a rapidly growing business, such as that associated with
K12 Inc., would bias upward the terminal value.
The case explains that some analysts were skeptical of the magnitude of
the revenue growth forecasts in case Exhibit 7, claiming that revenue
growth is better justified at 15% over the near term and 3% to 4% over the
long term. The instructor can solicit threats to the projected revenue path
that include ongoing declines in economic conditions, increased
competition, and difficulties in expanding outside the United States such as
product, marketing, and intellectual property adjustments. Adjusting the
model to incorporate this reduction in revenue growth decreases the
implied share value from $31 in Exhibit TN1 to under $20. Given the
profitability of the business, revenue growth is an important value driver.

It is worth emphasizing that the valuation of unseasoned equity is usually


highly uncertain. The Rosetta Stone case provides a platform to illustrate
this uncertainty. In order to appreciate the riskiness of any IPO valuation,
one must recognize the magnitude of the uncertainty in the business
forecasts. The companion Darden case JetBlue Airways IPO Valuation
(UVA-F-1415) provides a context for illustrating this point with an arguably
even larger amount of uncertainty.
8. What is an IPO and why is it such a big deal? Is this a good idea for
Rosetta Stone?
This question is designed to briefly review any institutional questions
students have on the IPO process. Exhibit TN2 provides a summary
adapted from the one in the case of the timeline for a typical U.S. IPO.
The instructor may solicit a critical evaluation of the costs and benefits of
public offerings and then tease out the relative importance of such
arguments to Rosetta Stone management. At the time, Rosetta Stone
management claimed that the IPO was impelled by a need for capital to
sustain its aggressive growth plans, by an interest in motivating employees,
and by a desire to assist its private-equity investors in offsetting the large
losses they were sustaining in their portfolios during this period of
economic contraction. Generic benefits and costs of going public might
include the following:
Potential benefits
* Improves access to capital market
* Increases liquidity of entrepreneur/private investor wealth
* Generates positive employee-compensation incentives
* Builds firm credibility with customers and employees
* Exposes management to public scrutiny (encourages value creation)
Potential costs

* Consumes company resources


* Reveals information to competitors
* Exposes management to public scrutiny (forces management to
emphasize short-run over long-run performance)
9. What offer price would you set for the Rosetta Stone IPO?
This question invites a wrap-up of the case by discussing the strategy for
pricing an IPO. Using a student-based estimate of the market value of a
share of Rosetta Stone stock, the instructor can invite students to share
their perspective on whether the stock should be priced above or below the
market value. By setting the price above the market value, Rosetta Stone
increases the potential proceeds from the offering but decreases the
likelihood that investors will fully buy the deal, have a good experience with
their investment, and not sue management. This discussion provides a
good platform for examining the IPO underpricing puzzle. Exhibit TN2
provides a handout that includes some of the leading explanations of why
firms tend to underprice their public shares.
Epilogue
Late Wednesday, April 15, 2009, management set the price at $18 per
share, a dollar above its expected price range. The offer price was at 9
times EBITDA. Morgan Stanley and the syndicate of underwriters
immediately contacted the investors in their book to begin selling the 3.125
million new shares and the 3.125 million private equity holder shares. The
underwriters kept $1.26 for each share sold as a commission for a total fee
of $7.9 million. The total offering netted $52.3 million for Rosetta Stone and
$52.3 million for the private equity investors. Bridgepoint Education went
public at the same time, but a poor showing on the road forced
management to substantially lower the offer price from the filing range to
just under 8 times EBITDA.
The next day the Rosetta Stone team gathered on the podium at the New
York Stock Exchange and rang the opening bell. The opening trade for
Rosetta Stone stock (ticker symbol RST) was at $25, 39% above the offer
price. The total equity market capitalization for Rosetta Stone was valued at

more than $500 million. That first day, 8.3 million shares traded at between
$24 and $26. The U.S. IPO market was back. Tom Adams and Phil Clough
were delighted with the buzz generated by the deal and the first-day pop in
returns.
The share-price performance over the remainder of the year is provided in
Exhibit TN3. Of particular note is the management announcement in midAugust that, due to rising operating costs, the quarterly and annual
earnings outlook would be substantially lower than anticipated. As part of
the announcement, Rosetta Stone canceled the follow-on offering of
another 4 million shares held by its private equity investors. The price of
Rosetta Stone stock plunged 26% with the announcement and failed to
recover during the remainder of the year.
In subsequent years, Rosetta Stone failed to live up to its IPO expectations,
as revenue growth was 21% for 2009 and just 3% in 2010. EBIT for 2010
came in at under $13 million.
Exhibit TN1
ROSETTA STONE: pricing the 2009 IPO
Company Valuation
Exhibit TN2
ROSETTA STONE: pricing the 2009 IPO
Life Cycle of a Typical U.S. IPO Transaction
Event time (in days) Event
< 0 Underwriter selection meeting.
0 Organizational all-hands meeting. Quiet period begins.
1544 Due diligence. Underwriter interviews management, suppliers, and
customers; reviews financial statements; drafts preliminary registration
statement. Senior management of underwriter gives OK on issue.

45 Registration (announcement) date. Firm files registration statement with


SEC; registration statement is immediately available to the public.
4575 SEC review period. SEC auditor reviews for compliance with SEC
regulations. Underwriter assembles syndicate and prepares road show.
50 Distribute preliminary prospectus (red herring).
6075 Road show. Underwriters and issuing firms management present
offering to interested institutional investors and build book of purchase
orders.
7599 Letters of comment received from SEC; amendments filed with SEC.
99 Effective date. Underwriter and firm price offering. SEC gives final
approval of registration statement.
100 Public offering date. Stock issued and begins trading.
108 Settlement date. Underwriter distributes proceeds to issuing firm.
After market Underwriter may support new equity by acting as market
maker and distributing research literature on issuing firm.
Exhibit TN3
ROSETTA STONE: pricing the 2009 IPO
Evidence on IPO Underpricing
Winners Curse. Uninformed investors demand rationed for good firms and
not for poor firms owing to informed investors participation in good IPOs
only. Underpricing gives uninformed investors normal return.1
Evidence: In countries where share allocation is transparent (e.g.,
Singapore and Finland), investors receive more shares of overpriced
offerings so that average profits are zero.2
Monopsony. Small number of underwriters following any particular industry
allow for potential monopsony profits.3

Evidence: In support, the severe average underpricing of 1980 was wholly


concentrated among a few regional underwriters within the petroleum
industry.4 Against support, an underwriter that takes itself public tends to
underprice itself.5
Lawsuit Avoidance. To avoid litigation for misrepresenting stock to
shareholders, firms/underwriters discount initial price.
Evidence: In support, offerings prior to the Securities Act of 1933 (which
holds companies responsible for misrepresentation) tend to be less
underpriced than offerings after 1933.6
However, firms that are sued following their IPO tend to be just as
underpriced as firms that are not sued.7
Exhibit TN3 (continued)
Reputation. Firms better able to access capital markets in future if they
leave a good taste in investorsmouths.8
Evidence: Little empirical support has been found for a relationship
between underpricing and subsequent offerings.9
Censored Distribution. Underwriters correctly price, on average, but stockstabilization efforts remove the left-hand side of nonstabilized, first-day
distribution of returnsleading to average positive performance.
Evidence: A disproportionate number of IPOs have first-day returns of zero.
IPOs with first-day returns of zero tend to experience negative returns over
the first month, suggesting that they are temporarily held above their true
value.10
Bandwagon. If investors pay attention to IPO demands on other investors,
bandwagon effects can create excessive demand for some offerings.11
Exhibit TN4
ROSETTA STONE: pricing the 2009 IPO

After-Market Share-Price Performance, 2009


Data source: Yahoo! Finance.
-------------------------------------------[ 1 ]. It may be worth demonstrating that cash flow multiples such as EBIT
and EBITDA are economically related to the constant-growth model. For
example, the constant growth model can be expressed as follows:
.
Rearranging this expression gives a free cash flow multiple expressed in a
constant-growth model.
This expression suggests that cash-flow multiples are increasing in the
growth rate and decreasing in the WACC. In the following table, one can
vary the WACC and growth rate to produce the implied multiple.
| | | WACC | |
| | 8% | 10% | 12% |
| 0% | 12.5 | 10.0 | 8.3 |
Growth | 2% | 16.7 | 12.5 | 10.0 |
| 4% | 25.0 | 16.7 | 12.5 |
| 6% | 50.0 | 25.0 | 16.7 |
[ 2 ]. This supplement was prepared by Associate Professor Michael J.
Schill for use with the case Rosetta Stone: Pricing the 2009 IPO (UVA-F1613).
[ 4 ]. 1 Kevin Rock, Why New Issues Are Underpriced, Journal of
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[ 5 ]. 2 Francis Koh and Terry Walter, A Direct Test of Rocks Model of the
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the Long-Run Price Performance of Initial Public Offerings in Finland,
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[ 7 ]. 4 Jay Ritter, The Hot Issue Market of 1980, Journal of Business vol.
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[ 8 ]. 5 Chris Muscarella and Michael Vetsuypens, A Simple Test of Barons
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[ 9 ]. 6 Seha Tinic, Anatomy of Initial Public Offerings of Common Stock,
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[ 11 ]. 8 Franklin Allen and Gerald Faulhaber, Signaling by Underpricing in
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Thomas Chemmanur, The Pricing of IPOs, A Dynamic Model with
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[ 12 ]. 9 Narasimhan Jegadeesh, Mark Weinstein, and Ivo Welch, An
Empirical Investigation of IPO Returns and Subsequent Equity Offerings,
Journal of Financial Economics vol. 34 (1990), 15376; Roni Michaely and
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Selection and Signaling Theories, Review of Financial Studies vol. 7
(1994), 279313.

[ 13 ]. 10 Judith Ruud, Underwriter Price Support and the IPO


Underpricing Puzzle, Journal of Financial Economics vol. 34 (1993), 135
51.
[ 14 ]. 11 Ivo Welch, Sequential Sales, Learning, and Cascades, Journal
of Finance vol. 47 (1992), 695732.