The Office has become a kind of phenomenon in the past few years. It’s been trending in the top 10 shows for months now. Its probably one of the best deals Netflix made.
I know people who play it in the background while working.
There might be some spoilers ahead, but the show went off-air seven years ago!
In season 5, Micheal Scott quits his job and decides to start his own business called Micheal Scott Paper Company(MSPC). His primary strategy is to steal clients from his old company Dunder Mifflin(DM). There are some hiccups along the way, but in just a month, Micheal manages to get a large chunk of DM’s clients. In fact, he makes enough damage to get the company’s CFO’s attention. CFO, David Wallace, drives down to Dunder Mifflin Scranton’s office to find a resolution and stop this bleeding of DM’s profitable clientele.
After consulting with the Scranton branch’s top salesmen, they decide to buyout MSPC. Both parties get into a room and talk numbers. David’s first offer was for $12,000 to buyout Micheal Scott Paper Company, which is immediately rejected, citing it was “insultingly low.”
The second offer was for $60,000. This got the Micheal and team excited. $60,000 for a month’s work is not bad at all!
But on second thought, Micheal decides that they need jobs, not a one-time payment. They need money coming in every month.
What follows is one of the best negotiations of Micheal’s life. He manages to convince David to give Micheal, Pam (former Dunder Mifflin receptionist), and Ryan Howard(former vice-president at Dunder Mifflin and recent bowling alley employee) their jobs back. He even demands that Pam starts as a salesperson instead of a receptionist.
David agrees to all the terms of the negotiation, and both parties leave the room satisfied. Of course, Micheal Scott paper company was broke as they were selling their products at a much lower price point than their competitors. David, even offering to buyout MSPC, was a godsend. Good for Micheal!
But this got me wondering, what is the fair value of Micheal Scott Paper Company? Did David jumped the gun and overpaid? Or is he the brilliant CFO that bought great assets at a low price?
To find out, I’ll try first to calculate a fair value for MSPC and then calculate how much it would cost DM to re-hire Micheal, Pam, and Ryan.
The fair value of MSPC:
Before we move on, we need to take a step back. A fundamental concept for valuing any asset is the Time value of money.
I’ll let Fred Wilson take over to explain Time value of money:
Money today is generally worth more than money tomorrow.
Money in your pocket, cash in hand, is worth more than cash that you don’t actually have in hand. If you think about it that simply, everyone can agree that they’d rather have the cash in hand than the promise of the same amount at some later day.
And interest rates are used to calculate exactly how much more the money is worth today than tomorrow. Let’s say that you’d take $900 today instead of $1000 exactly a year from now. That means you’d accept a 11.1% “discount rate” on that transaction.
Interest rates and discount rates are generally the same thing.
So if the interest rate describes the time value of money, then the higher it is, the more valuable money is in your hands and the less valuable money is down the road.
Now that we have that let’s move on to the Discounted Cash Flow(DCF) model.
There are few components to DCF valuation, an asset. And each part comes with its own set of assumptions.
Here are some of the elements of my valuation system:
- Profit margin
- Earnings Growth
- Cost of capital/expected rate of return
- Terminal cash flow
The complete system looks something like this:
The first thing we need is MSPC’s annual revenue.
We will have to estimate how much revenue Micheal Scott Paper Company stole from Dunder Mifflin.
Since we can’t find financial docs of MSPC or DM, we’ll look at the next best thing: Office Max. I dug up Office Max’s annual report from 2007.
Here are some of the missing pieces we need:
OfficeMax‘s yearly revenue in 2007 from the “OfficeMax, Contract” segment(most similar to DM’s business model) was about $5 billion.
Since DM is a much smaller company and only operates on the east coast, we’ll assume DM is about 10% the size of Office Max. That makes DM’s annual revenue of ~$500 million.
Next, we need to know how much the Scranton branch’s revenue was in 2007. We know that the Scranton branch is the most profitable branch in the company. The best salesman at the company also works for the Scranton branch!
DM had 7 branches operational at the time.
Let’s apply the Pareto principle, meaning 20% of branches bring in 80% of the revenue or 2 branches bring in $400 million in revenue. Let’s split that between Scranton and some other branch.
To summarize, the Scranton branch brought in about $200 million in sales for the year 2007.
Let’s say Micheal was able to steal 3% of DM’s revenue. That makes revenue of MSPC: ~$6 million.
We now have enough to begin our DCF model.
Next, we need to estimate the net profit margin of MSPC. Office Max and Staples had about 3-5% margins in 2007. Let’s give the MSPC 5% profit margin.
That makes annual profit or earnings of MSPC of $300k.
We can pause here and do a back of the envelope calculation to estimate the value of MSPC. A general rule of thumb is that a publicly-traded company is worth about 20 times its profit or a 20 PE, whereas a private company is worth about 10 times its annual profit. Since MSPC will make an estimate of $300k in profit, that puts its value at $300k x 10 = $3 million.
Let’s look at a more sophisticated model.
We will grow MSPC’s profit by 5% every year for the next 10 years and then apply a “discount rate” or returns that we expect to make on an investment. US markets have returned about 8% returns over the long term; we can use that as our discount rate. We will ignore the terminal value for this model.
This model puts MSPC’s value at $2.6 million.
Now that we know MSPC is worth between $3-$2.6 million, how much did David Wallace agreed to pay for it?
That is pretty easy to calculate.
I’m assuming Micheal’s salary is $75k, Pam’s $55k, and Ryan’s 44k, totaling DM’s liabilities to $170k.
Let’s say they get raises of about 3% each year for the next 10 years and then discount those salaries by the same discount rate to bring DM’s liabilities to present value. That is a total payment of ~$1.4 million.
To summaries, Micheal Scott Paper Company’s fair value is ~$2.6 million, and David Wallace will end up paying ~$1.4 million.
In other words, buying MSPC will most likely generate a value of ~2.6 million for DM, for which they are only paying ~$1.4 million. That is a total steal for David Wallace and Dunder Mifflin. Good job, David!
This, of course, is an oversimplification of how valuations are done but feel free to check out the complete model here. Make a copy and change the numbers that you disagree with. Yellow cells are inputs; green ones are automatically calculated. As you would see there are quite a bit of yellow/input cells and each yellow cell comes with assumptions attached to them. Any model is as good it’s assumptions.
Valuation is more art than science.
Also, none of this would have happened if David Wallace returned Micheal’s calls.
Let me know what you think? What incorrect assumptions I made? What did I overlook?