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A few have wondered about the utility of using DCF in our K12 analysis posted the other day (see The Long-biased Forensic Analysis is Now Available to the Public). In particular, a question was brought to me as follows: "Isn't WACC at 7.4% really low for doing the DCF? You can't really use CAPM, because the beta would be skewed somewhat because the company just isn't that old. Using the build up method, I'm coming up with a WACC in the 11% plus range. Which would then drive down the per share price."

I would like to take the time to explain our conservative methodology.

We agree that LRN has a relative short trading history (approximately 1 ½ years) which could possibly skew beta computations and the resulting cost of equity derived through CAPM model. However, alternative forms of estimating cost of capital including ‘bond yield plus risk premium' and ‘build-up' method could also be equally skewed. LRN does not have any public traded debt to compute bond yield for ‘bond yield plus risk premium' method, while the build-up method would also require several assumptions relating to company size premium, industry premium and company specific premium that would require subjective assumptions based on individual perception. As a result we had relied on the most widely used approach in the industry - the CAPM model which suggest a valuation of $30.7 per share (assuming WACC of 7.3%).

If we look at some of the relative valuation multiples, we can see that the company seems to be undervalued. For instance the Price Earnings Growth (PEG) of LRN is 0.31x compared with average PEG ratio of 0.78x for its peers (please see the relative valuation section in the financial model), suggesting that LRN is undervalued when P/E is adjusted for future earnings growth. The current PEG ratio of the company would imply 150% premium for LRN (which would suggest a valuation of $44 per share) while we had been conservative in our premium estimates with just 25% premium (valuation of $22) on P/E basis. EV/EBITDA based relative valuation approach is also implying a substantial upside for the company with a valuation of $29.5 which is close to valuation derived through DCF methodology ($30.7).  

Also we wanted to highlight that we have tried to be realistic (besides being conservative) in some of our other estimates including revenue growth, EBITDA margins and terminal growth rates that could possibly partially offset lower WACC used. We have assumed compounded annual revenue growth of 27.6% during 2008 and 2013 and average EBITDA margin of 13.3% (2008-2013) against management guidance of 25-30% for annual revenue growth and 18-20% EBITDA margins over the next five years. These assumptions are also on lower side compared with estimates of some of the leading analysts.  Also we had used terminal growth of just 3.0% in our estimates against terminal growth of 4.0% which could possibly be reasonable to take for virtual school industry. Had we used WACC of 10.4% and terminal growth of 4.0% with conservative margin assumption (base model), our valuation would have been $19.6 per share, while valuation would have been $36.5 had we used higher margins based on management guidance.

Sensitivity Analysis: (base model with EBITDA margins of 8-10%)

 

Terminal Growth Rates

WACC

       30.71

2.0%

2.5%

3.0%

3.5%

4.0%

6.9%

         29.1

         31.6

         34.8

         39.0

           44.5

6.4%

         32.6

         35.9

         40.2

         45.9

           54.0

7.4%

         26.2

         28.2

         30.7

         33.8

           37.8

8.4%

         21.8

         23.2

         24.8

         26.7

           29.0

9.4%

         18.7

         19.6

         20.7

         21.9

           23.4

 

10.4%

         16.3

         17.0

         17.7

         18.6

           19.6

 

Sensitivity Analysis: (EBITDA margins of 15-17%)

 

Terminal Growth Rates

WACC

       56.21

2.0%

2.5%

3.0%

3.5%

4.0%

6.9%

         53.2

         57.9

         63.8

         71.5

           81.7

6.4%

         59.7

         65.8

         73.7

         84.3

           99.2

7.4%

         47.9

         51.6

         56.2

         61.9

           69.3

8.4%

         39.8

         42.3

         45.2

         48.7

           53.0

9.4%

         34.0

         35.7

         37.7

         40.0

           42.7

 

10.4%

         29.6

         30.8

         32.2

         33.8

           35.6