Daves Chapter 7

1. Daves Chapter 7 Multiyear Projections and Valuation DES Chapter 7

2. Current Information • Current market price is $40.12 per share • Given you knowledge about Van Leer, is this a fair price? • You must create multi-year financial projections for Van Leer, perform a valuation, and compare the value to the market price of the stock. DES Chapter 7

3. Short-term, Long–term • There are three types of time periods in these projections: • The short-term, in which there is plenty of specific information on which to base projections • The steady state, in which the firm is assumed to be at constant growth and some form of competitive equilibrium. It starts with the last year of projections. • The long-term is between the short term and the steady state--general firm and industry information is used to base projections. DES Chapter 7

4. How long? • The point at which short-term specific information gives way to reliance on more general industry and market movements varies from firm to firm and industry to industry. • Frequently 3 to 5 years is the length of the short-term specific projections. DES Chapter 7

5. The Short Run • Just about anything can happen. • Reasonableness of your projections depends on firm-specific knowledge and history of the firm. DES Chapter 7

6. Over the Long-term • It is difficult to maintain high growth for a long time • Constrained by industry size • Constrained by size of economy • Competitors will enter profitable industries DES Chapter 7

7. Projecting Operating Profit • Long-run sales growth • Real growth about 2% to 3% for U.S. economy most years • Inflation? 2% to 3%? • Adds to 4% to 6%, and higher when inflation is higher. • What about Van Leer? DES Chapter 7

8. Projections for Van Leer: Sales Growth Year 2004 2005 2006 2007 2008 2009 after Growth 11% 8% 7% 7% 6% 6% 6% DES Chapter 7

9. Cost of Goods Sold • To maintain profit margins a firm must: • Establish and defend a competitive advantage. • Like brand identity, patents, reputation for quality, corporate culture, supply chain, technology that allows cost control. • To improve profit margins a firm must: • Improve its competitive position. • Otherwise, profit margin declines. DES Chapter 7

10. COGS for Van Leer • Assume Van Leer can raise prices in 2004, and hold for 2 years. After that, competition will drive down prices: 2004 2005 2006 2007 2008 after COGS% 62.5% 62.5% 62.5% 63% 64% 64% DES Chapter 7

11. SGA • How does SGA interact with CGS? • With sales growth? • Ask yourself: If sales growth is projected to be larger in the future than in the past, how (specifically) is this going to be accomplished? Are there costs associated with this plan? DES Chapter 7

12. Van Leer’s SGA and depreciation • SGA will increase slightly in 2004 to 22.5% of sales and then remain there. • Depreciation will remain at 15% of net PPE. DES Chapter 7

13. Projected parameters Actual Actual Actual Actual Ratios to calculate 2001 2002 2003 Average operating profit Sales Growth na 12.4% 5.9% 9.2% CGS % of sales 61.9% 66.2% 64.0% 64.0% SGA % of sales 23.8% 21.7% 21.5% 22.3% Depreciation % net PPE 14.9% 15.0% 15.0% 15.0% Ratios--historical DES Chapter 7

14. Projected 2004 2005 2006 2007 2008 2009 after Ratios to calculate operating profit Sales growth rate 11.0% 8.0% 7.0% 7.0% 6.0% 6.0% 6.0% COGS / Sales 62.5% 62.5% 62.5% 63.0% 64.0% 64.0% 64.0% SGA / Sales 22.5% 22.5% 22.5% 22.5% 22.5% 22.5% 22.5% Depreciation / Net PPE 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% Ratios--projected DES Chapter 7

15. Projecting operating capital • Cash • Reduce to 3% of sales from 2004 to 2006, then 2% in 2007 and thereafter. • Inventory • 11% of sales in 2004 and thereafter. • Accounts receivable • 7.6% of sales in 2004 and thereafter. DES Chapter 7

16. Operating capital… • Net PPE as % of sales • Depends on whether the firm is at full capacity or not. • Currently at 95% capacity, and must build a new plant to meet growth. • PPE will increase from 30% to 34% of sales in 2004. Will drop to 31.5% and then to the average of 30.8% by 2006. DES Chapter 7

17. Operating capital • Accounts payable as % of sales • Days payable is about 45 days, which is the industry average, so Van Leer will keep AP at the historical average of 8.1% of sales. • Accrued expenses have been 1% of sales and will remain there. DES Chapter 7

18. Act ual Actual Actual Actual Ratios to calculate 2001 2002 2003 Average operating capital Cash/sales 5.0% 5.0% 5.0% 5.0% Inventory/sales 8.9% 9.0% 10.0% 9.3% A R/sales 7.7% 7.4% 7.5% 7.6% Net PPE/ sales 32.7% 29.7% 30.0% 30.8% A/P / sales 9.5% 7. 4% 7.5% 8.1% Accrued exp./sales 1.0% 1.1% 1.0% 1.0% Historical Ratios DES Chapter 7

19. Ratios to calculate operating capital DES Chapter 7

20. Projecting operating taxes • Taxes have averaged 39.7% of pre-tax income, and are projected to remain there. DES Chapter 7

21. Dividend growth rate • Van Leer is stabilizing its historically erratic dividend policy. Growth for 2004 through 2007 is set at 10%. 2008 growth is projected to be 8%, and dividend growth is projected to be 6% thereafter. DES Chapter 7

22. Target debt ratio and interest • Historically, 16% of operating capital has been financed with long-term debt. This is expected to be reduced to 15%. • Short-term and long-term debt is expected to cost 9%, and the yield on short-term investments is expected to be 3%. DES Chapter 7

23. Balancing • Projected assets too big? Short-term debt is the plug—after driving short-term investments to zero. • Projected liabilities too big? Short-term investments are the plug—after driving short-term debt to zero. DES Chapter 7

24. Actual Actual Actual 2001 2002 2003 Net Sales 840.0 944.0 1,000.0 Cost Of Goods Sold 520.0 625.0 640.0 Selling, general & administrative 200.0 205.0 21 5.0 Depreciation 41.0 42.0 45.0 Operating profit 79.0 72.0 100.0 Interest income 0.0 1.0 0.0 Interest expense 9.0 9.0 10.0 Earnings before taxes 70.0 64.0 90.0 Taxes 28.0 25.0 36.0 42.0 39.0 54.0 Net income Dividends 12.0 11.0 16.0 Additions to RE 30.0 28.0 38.0 Historical Income Statement DES Chapter 7

25. Projected Income Statement DES Chapter 7

26. Actual Actual Actual 2001 2002 2003 Cash 42.0 47.0 50.0 Short - term investments 10.0 15.0 25.0 Inventory 75.0 85.0 100.0 Accounts receivable 65.0 70.0 75.0 Total current assets 192.0 217.0 250.0 Net PP&E 275.0 280.0 300.0 467.0 497.0 550.0 Total assets Historical Assets DES Chapter 7

27. 2004 2005 2006 2007 2008 2009 33.3 36.0 38.5 27.5 29.1 30.8 Cash investments Short term - - 30.3 63.5 83.1 104.0 122.1 131.9 141.1 151.0 160.0 169.6 Inventory 84.4 91.1 97.5 104.3 110.6 117.2 Accounts receivable 239.8 258.9 307.3 346.3 382.8 421.7 Total current assets 377.4 377.6 395.1 422.7 448.1 475.0 Net PP&E 617.2 636.6 702.4 769.0 830.8 896.7 Total assets Projected Assets DES Chapter 7

28. Actual Actual Actual 2001 2002 2003 Accounts payable 80.0 70.0 75.0 Accrued expenses 8.0 10.0 10.0 Short - term debt 50.0 30.0 25.0 Total current liabilities 138.0 110.0 110.0 Long - term debt 54.0 84.0 99.0 Total liabilities 192.0 194.0 209.0 125.0 125.0 125.0 Common stock Retained earnings 150.0 178.0 216.0 Total common equity 275.0 303.0 341.0 467.0 497.0 550.0 Total liabilities and equity Historical liabilities DES Chapter 7

29. Projected Liabilities DES Chapter 7

30. Debugging—what is reasonable? • Is it reasonable for sales to be so large? • how big is company relative to industry? • relative to economy? • How much is being invested in assets from year to year? Are these increases similar to other years? DES Chapter 7

31. Debugging • How much are dividend payments? • Are they sustainable? • What happens to short-term debt? • Is it increasing over the period? • What happens to short-term investments? • Is it increasing over the period? • May need to reconsider financing mix. DES Chapter 7

32. Debugging • What are the projected ROICs? • Are they comparable with previous years? • Comparable with those of other companies in the industry? • What is the projected growth in FCF from year to year? DES Chapter 7

33. Using the Projections for Valuation • Calculate projected free cash flows • Calculate WACC • Calculate projected horizon value • Discount FCFs and horizon value at WACC • Add in short-term investments • Subtract debt • Divide by shares outstanding DES Chapter 7

34. Free Cash Flow DES Chapter 7

35. Free Cash Flow Projected 2004 2005 2006 2007 2008 2009 Operating Income 109.9 123.2 133.1 135.6 129.2 136.9 Tax on Operating 43.6 48.9 52.9 53.8 51.3 54.4 Income NOPAT 66.3 74.3 80.3 81.8 77.9 82.6 138.8 149.9 160.3 157.8 167.3 177.3 Net Operating WC Net Operating Long Term Assets 377.4 377.6 395.1 422.7 448.1 475.0 Total Net Operating Capital 516.2 527.5 555.4 580.6 615.4 652.3 Investment in net operating capital 76.2 11.3 27.9 25.2 34.8 36.9 Free Cash Flow -9.9 63.0 52.3 56.6 43.1 45.7 growth in FCF -144.9% na -16.9% 8.2% -23.9% 6.0% ROIC 15.1% 14.4% 15.2% 14.7% 13.4% 13.4% DES Chapter 7

36. Cost of Equity • Using the capital asset pricing model (CAPM): • Van Leer’s beta is 1.4. • The risk-free rate is 6%. • The market risk premium is 5%. rS = rRF + beta (RPM) = 6% + 1.4 (5.0%) = 13% DES Chapter 7

37. Cost of Capital… Target debt is 19.8%, target equity is 80.2% WACC = (1-T)rDwD + rSwS = (1 - 0.397)(9.0%)(0.198) + (13%)(0.802) = 11.5% DES Chapter 7

38. 2004 2005 2006 2007 2008 2009 Horizon Value 879.80 Free Cash Flow (9.89) 62.95 52.34 56.61 43.07 45.65 FCF + Horizon Value 925.45 Valuation (9.89) 62.95 52.34 56.61 43.07 DES Chapter 7

39. Valuation • Present value at the WACC of 11.5% is $622.79 million. • This is as of the end of 2003 • Debt at end of 2003 is $124 million, short-term investments are $25 million DES Chapter 7

40. Valuation • Equity = $622.79 + $25 – $124 = $523.79 million. • There are 10 million shares, so per share is $52.38 per share. • Compared to the existing market price of $40.12, this Van Leer appears to be a good investment at this time. DES Chapter 7