Estimating the Intrinsic Value of Rosetta Stone using DCF Model

The assignment content discusses the valuation of Rosetta Stone using a Discounted Cash Flow (DCF) model. The DCF model is used to estimate the intrinsic value of the company, which is then compared to the offer price for its initial public offering (IPO). The content also includes references from various academic journals and books on topics related to firm profitability and financial condition.

FINANCING ENTERPRISE
INITIATIVE

TABLE OF CONTENTS
Rosetta Stone introduction...............................................................................................................3
1. Characteristics of Rosetta Stone's business model and its strategy....................................3
2. IPO process and its advantages as well as disadvantage....................................................4
3. Market-Multiples approach to identify range of prices for an IPO....................................7
4. Market-Multiple approach and its use for identifying fair value of shares........................7
5 Reasonable rate of return for Rosetta Stone shares .........................................................10
6 Cash flow model and explanation on calculations...........................................................10
7 Offer price for IPO............................................................................................................12
REFERENCES..............................................................................................................................13
ILLUSTRATION INDEX
Illustration 1: Average of EV/EBITDA for 2008............................................................................8
Illustration 2: Average of EV/EBITDA for 2009...........................................................................8
Illustration 3: PE ratio for 2008.......................................................................................................8
Illustration 4: PE ratio for 2009.......................................................................................................9
Illustration 5: Valuation of shares....................................................................................................9
Illustration 6: Value of share............................................................................................................9
Illustration 7: Required rate of return............................................................................................10
Illustration 8: Calculation of cost of equity...................................................................................10
Illustration 9: Calculation of Enterprise value...............................................................................10
Illustration 10: WACC calculation................................................................................................10
Illustration 11: Calculation of cash flows......................................................................................11
Illustration 12: Computation of present value...............................................................................11
Illustration 13: Calculation of equity value...................................................................................11
Illustration 14: Calculation of intrinsic value of shares.................................................................12

Rosetta Stone introduction
Rosetta Stone is the firm that is across the globe for developing software's by using which
one can easily learn programming languages. Firm wants to bring its IPO in the market to raise
funds that will be used to make heavy investment in the business. In order to determine fair value
of share to determine offer price some specific methods like discounted cash flow and multiple
method are used in the report. At end of the report working notes are enclosed in image format
and briefly same are discussed.
1. Characteristics of Rosetta Stone's business model and its strategy
In current time period there is heavy demand of the experts that have expertise in specific
programming language. In this regard there are several websites where students visit and lean
new things. Rosetta stone develop its own software's by using which one can easily learn
programming languages. Firm is making available programming language related solutions to
the students and those who intends to learn programming language. With passage of time firm is
adding many new things in its software's or it can be said that it bring updates on same with
passage of specific duration. Rosetta stone understand that competition is fierce and it is very
important to remain in the market. Hence, it is focusing on eliminating its competitors and in this
regard in past years it purchase many firms. Some of the firms that are acquired by the Rosetta
stone are Tell Me More and Livemocha etc (Cullinan and Zheng, 2014). The main advantage of
merger and acquisition is that through this firm is able to get access to infrastructure that belong
to other company. Firms does not need to spend time on developing its own infrastructure of
technology base. It can be said that merger and acquisition that are done by the firms to great
extent helps firm in increasing its business size. Rosetta stone have individual customer's and
business customer's and according to there needs to develop its products. Company is paying
due attention on developing its core competency because it is a thing that provide edge to the
firm over its competitors. Firm is focusing on developing a workforce that is highly competent
and in this regard it is hiring talented candidates as its employees. The main thing that company
is doing is that it is not dependent on single product line in order to earn profit (Bricker and
Chandar, 2012). It can be said that firm is offering multiple products to meet the needs of
customer's. Presently, in its product portfolio there are products that meet needs of individuals,
business customers and government departments etc. it can be said that firm is focusing on same

type of product but in same it is offering different varieties to meet needs of different type of
people. Firm is focusing on innovating its existing product line and developing new features in
its product. It can be said that this is the thing that is differentiating firm from its competitors.
Rosetta stone makes investment on its research and development projects in order to enable itself
to add new features on its software. Firm understand that it needs to make heavy investment on
its project and on same time it is equal important to maintain profit in the business. Thus, it is
following cost control strategy in its business so as to elevate profitability in the business to
maximum level. In order to implement its cost control strategy firm is purchasing material in
optimum quantity and it is also following good cash management strategy in its business (Ayadi
and Wang, 2013). Gradually, Rosetta stone is shifting from its traditional product line and now it
is involved in developing varied sort of applications. This step will help firm is increasing its
customer's base. It can be said that this product line will to some extent reduce firm dependency
on traditional products.
2. IPO process and its advantages as well as disadvantage
There are many operations and process through which Rosetta stone needs to pass in order to
launch its IPO.SEC is the regulatory authority that looks after entire process of listing of shares
and launch of IPO. It laid down some important parameters or standard that firm which intends
to issue shares in the market needs to follow in order to issue shares. These standards are
determined in terms of profit that must be earn by the firm in number of years under specific
duration. There are many other parameters that an organisation need to pass in order to issue
IPO. Steps that company needs to follow in order to issue its shares are given below.
1. Creating pitch: It is well known fact that there are many steps that managers of an
organization needs to follow or comply with in order to issue shares. In this regard
management of the firm collect all required information and carry out detail discussion
reading preparation of plan that will be followed to complete all require formalities
(Fernández Gimeno and et.al., 2012). In this stage managers will undertake meeting with
the underwriters and will convince them to purchase shares in case they are not
subscribed partially by the public.
2. Kick-off meeting: After determining each and every thing managers of the Rosetta stone
will conduct meeting with the important entities that will play major role in in facilitating
operations related to launch of IPO in the market. Some of these entities are investment

bank and underwriters etc. Decision on number of things will be taken under this step by
taking advise from important stakeholders. In this stage it is member of the Investment
bank that will communicate the offer price for share at which shares can be issued in the
primary market. There are various models that are used by investment bank to determine
offer price of shares. Some of these methods are discounted cash flow and multiple
method. The work of preparation of prospectus is given to the investment banker and in
this meeting it present same before top managers. It is like a book in which detail
information is provided about the firm business its profitability, future plans and places
where it will make an investment. When investors will subscribe share at that time they
will receive prospectus (Branch, Ma and Sawyer, 2010). Prospectus are also available on
internet and investors can download same from firm website.
3. Filling registration statement and due diligence: In this stage registration statement is
filed in the office of SEC by the firm that wants to launch its IPO in the primary market.
In this stage copy of agreement that is signed by the firm with an underwriter is also filed
in the SEC. Along with this, documents like charter and a specimen of security will also
be filled with SEC. It is important for the firm to obtain due diligence certificate which is
proof of the fact that Rosetta Stone had followed all rules and regulations in systematic
way to launch its IPO. This certificate is issued after all documents are submitted by the
firm with SEC. It can be said that it is one of the most important step and after clearing
this stage one can launch its IPO.
4. SEC review: Under previous stage all required documents are submitted with SEC but
they are not checked by the regulatory authority. In this stage after issuance of due
diligence certificate documents are checked and verified by SEC. Detail procedure is
followed for verifying documents and it is ensured that fraud is not done by the firm to
list its shares. If in any case it is identified that firm dos not make available accurate
document that regulatory authority will send letter of comment to the firm and will give
20 days time to again fill registration form with the former entity (Lenkey, 2015).
5. Road show: In this stage firm will make an efforts to establish contact with the people or
large business entities and will asked them to make investment in firm shares. Road
shows of one to two weeks will be organized by the underwriter from firm side.

6. Pricing meeting: In this stage negotiation round is carried out with the underwriter in
relation to share price. Detail discussion is carried out on the extent up to which discount
will be given to the underwriters when they will make purchase of shares in case they
remain unsubscribe from general public.
7. Allocation: In this stage syndicate members of the firm will sale there shares in the
primary market and those who wants to make purchase of shares will buy same.
Underwriters will get information about same and under this copy of sales confirmation
will be provided to the underwriters (Kisaka, S.E. and et.al., 2014). It can be said that this
stage is also very important in IPO process.
8. Trading: It is a final stage in which trading get commenced and people or firms start
making investment in the firm. After ten days from commencing date purchase of shares
in the IPO get closed. After this security certificate is issued to the underwriter and
comfort letter is given to the individual.
Advantage of IPO
 The main advantage of IPO is that it helps firm in adjusting its finance cost. If firm will
only finance its operations by taking a debt then its interest cost will increase. Rosetta
Stone will need to pay interest every year irrespective of its profitability. On other hand,
in case of equity it is not necessary to pay dividend every year. It is clear that equity helps
in adjusting finance cost.
 When firm launch its IPO its name become popular among the people. This help firm in
establishing its business relationship with new entities. Contrary to this, if firm never
issue shares in primary market then other entities after considering lots of factors
establish business relationship with the firm (Souther,2016). It can be said that IPO not
only help firm in raising capital but it also help it in creating its good image among the
customer's. By issue of shares company bring balance in its capital structure and maintain equal
proportion of both in the IPO. This help firm in maintaining its good performance in the
business.
Disadvantage of IPO
 When firm issue its shares control of owners of the firm get diluted and there decision
making power get reduced.

 Cost of equity is always higher then equity which means that amount of dividend paid by
the firm is always high then interest amount.
3. Market-Multiples approach to identify range of prices for an IPO
It totally different methods of valuation because under this method if one is doing
valuation of shares then he will make use of other companies shares that belongs to same price
range. This method is commonly used by the investors in order to do valuation of shares. In the
market multiple method there are number of things that are considered for valuation of shares
like earning per share, PE ratio and market price. Price earning ratio is one of the most important
ratio because it helps one to measure whether shares are overvalued or undervalued (Ji and Kim,
2013). Under this method first of all company PE ratio is computed and then it is compared with
the industry price earning ratio in order to identify whether shares of the specific firm are fairly
valued. If any case if equity research analyst find that PE ratio of the firm is above industry PE
ratio then it means that shares are overvalued and they are not trading in stock exchange at fair
value. Contrary to this if it is identified that price earning ratio of the firm is below industry ratio
then it indicate that firm shares are undervalued and they are available at fair value. In this case
companies like Apollo Group Inc and American Public Education Inc etc are taken in to
consideration for doing calculation. DCF analysis is the another method of valuation that is used
in this report which is used to compute intrinsic value of shares. In this enterprise value is also
computed which reflects entire capitalization amount of the firm. It can be said that by using
multiple methods shares are valued in proper way.
4. Market-Multiple approach and its use for identifying fair value of shares
Market multiple method and discounted cash flow model both are different approaches that are
used for doing valuation of shares. The main difference between both methods is that in market
multiple approach competitors firms data is also taken in to consideration (Cullinan and Zheng,
2012). Whereas, in case of discounted cash flow model firm data is used to do valuation of share.
Following calculations are done to do valuation of shares on the basis of market multiple
approach.

Illustration 1: Average of EV/EBITDA for 2008
Illustration 2: Average of EV/EBITDA for 2009
Illustration 3: PE ratio for 2008

Illustration 4: PE ratio for 2009
In this approach EV/EBITDA is another figure that is taken in to account. Mean value of
EV/EBITDA is computed to measure fair value of Rosetta Stone shares. In order to do valuation
of shares of Rosetta Stone by using PE ratio its competitors price earning ratio figures are taken
in to account. After collecting data related to price earning ratio of competitor firms there
average is calculated. This average price earning ratio is assumed as industry PE ratio because all
major companies relevant ratio figures are taken in to consideration in calculation that is done
by using market multiple approach. In this report under market multiple approach PE ratio and
EV/EBITDA are two different figures of rival companies that are taken in this report. By making
use of rival firms PE ratio industry average price earning ratio is computed. On the basis of PE
ratio it is identified that fair value of shares is 118.
5 Reasonable rate of return for Rosetta Stone shares
Illustration 6: Value of share
Illustration 5: Valuation of shares

Required rate of return is 2.41% which means that for taking risk that is equivalent to beta value
it is necessary to earn return of 2.41% so that appropriate return can be earned for risk that is
taking on investment.
6 Cash flow model and explanation on calculations
Illustration 7: Required rate of return
Illustration 8: Calculation of cost of
Illustration 9: Calculation of Enterprise value
Illustration 10: WACC calculation

Illustration 11: Calculation of cash flows
Illustration 12: Computation of present value
Illustration 13: Calculation of equity value

In this model first of all WACC is computed using cost of equity, interest, market capitalization
and debt values. This is computed by using formulae Ke*weight of equity+Kd*weight of
debt*(1-tax rate) (Discounted cash flow model (DCF) analysis, 2016). After this cash flows are
computed on the basis of inputs provided by PDF. Finally, present value of cash flow is
computed and then by using equity value intrinsic value is computed.
7 Offer price for IPO
Intrinsic value revealed by DCF model is offer price for IPO. This is because it is a model which
consider cash flows to compute fair value of shares (Falkenbach, Niskanen and Kiehelä, 2013).
On other hand, in case of market multiple approach market data is considered which does not
have any relation with firm profitability and financial condition. Hence, DCF model intrinsic
value is selected as offer price for IPO of Rosetta Stone.
Illustration 14: Calculation of intrinsic
value of shares

REFERENCES
Books & journals
Ayadi, M.A. and Wang, Y., 2013. Canadian investors and the discount on closed-end funds.
Journal of Financial Services Research. 43(1). pp.69-98.
Branch, B., Ma, A. and Sawyer, J., 2010. Around‐the‐Clock Performance of Closed‐End Funds.
Financial Management. 39(3). pp.1177-1196.
Bricker, R. and Chandar, N., 2012. Relevance, reliability and restricted security fair values: a
look at investment trusts. Managerial Finance. 38(12). pp.1203-1225.
Cullinan, C. and Zheng, X., 2012. Asset Liquidity and Mutual Fund Management Fees: Evidence
from Closed-End Mutual Funds. Accounting and Finance Research. 1(2). p.p139.
Cullinan, C.P. and Zheng, X., 2014. Valuation scepticism, liquidity benefits and closed‐end fund
premiums/discounts: evidence from fair value disclosures. Accounting & Finance. 54(3).
pp.729-751.
Falkenbach, H., Niskanen, J. and Kiehelä, S., 2013. Development and performance of the public
real estate investment sector in Finland. International Journal of Strategic Property
Management,.17(3). pp.233-247.
Fernández Gimeno and et.al., 2012. Los REITs españoles como vehículo de inversión y
financiación de la actividad inmobiliaria: las SOCIMI. Intangible capital. 8(2). pp.308-
363.
Ji, P.I. and Kim, S., 2013. Mean-reversion in closed-end fund discount: evidence from half-life.
Applied Economics. 45(32). pp.4503-4515.
Kisaka, S.E. and et.a., 2014. An Analysis of the Reverse Weekend Anomaly at the Nairobi
Securities Exchange in Kenya. Research Journal of Finance and Accounting. 5(13).
pp.154-165.
Lenkey, S.L., 2015. The closed-end fund puzzle: Management fees and private information.
Journal of Financial Intermediation. 24(1). pp.112-129.
Souther, M.E., 2016. The effects of takeover defenses: Evidence from closed-end funds. Journal
of Financial Economics. 119(2). pp.420-440.
Online
Discounted cash flow model (DCF) analysis, 2016. [Online]. Available through:<
http://macabacus.com/valuation/dcf/overview>. [Accessed on 9th August 2016].