Multiyear Projections and Valuation

1
DES Chapter 7

• Multiyear Projections and Valuation

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.

3
Short-term, Longterm

• 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.

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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.

5
The Short Run

• Just about anything can happen.
• Reasonableness of your projections depends on
  firm-specific knowledge and history of the firm.

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

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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?

8
Projections for Van Leer Sales Growth

• Year 2004 2005 2006 2007 2008 2009 after
• Growth 11 8 7 7 6 6 6

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.

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

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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?

12
Van Leers 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.

13
Ratios--historical
14
Ratios--projected
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.

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.

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.

18
Historical Ratios
19
Ratios to calculate operating capital
20
Projecting operating taxes

• Taxes have averaged 39.7 of pre-tax income, and
  are projected to remain there.

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.

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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.

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Balancing

• Projected assets too big? Short-term debt is the
  plugafter driving short-term investments to
  zero.
• Projected liabilities too big? Short-term
  investments are the plugafter driving short-term
  debt to zero.

24
Historical Income Statement
25
Projected Income Statement

26
Historical Assets
27
Projected Assets
28
Historical liabilities
29
Projected Liabilities
30
Debuggingwhat 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?

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.

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?

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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

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Free Cash Flow
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
36
Cost of Equity

• Using the capital asset pricing model (CAPM)
• Van Leers 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

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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

38
Valuation
(9.89)
62.95
52.34
56.61
43.07
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

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.