Multiyear Projections and Valuation 1 Current Information Current

Multiyear Projections and Valuation 1

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. 2

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. 3

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 shortterm specific projections. 4

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

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 6

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? 7

Projections for Van Leer: Sales Growth Year 2017 Growth 11% 2018 2019 2020 2021 2022 after 8% 7% 7% 6% 6% 6% 8

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. 9

COGS for Van Leer • Assume Van Leer can raise prices in 2017, and hold for 2 years. After that, competition will drive down prices: 2017 2018 2019 2020 2021 after COGS% 62. 5% 63% 64% 10

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? 11

Van Leer’s SGA and depreciation • SGA will increase slightly in 2017 to 22. 5% of sales and then remain there. • Depreciation will remain at 15% of net PPE. 12

Ratios--historical Projected parameters Ratiosto calculate operating profit Sales Growth CGS % of sales SGA % of sales Depreciation % net PPE Actual 2014 2015 2016 Average na 61. 9% 23. 8% 14. 9% 12. 4% 5. 9% 66. 2% 64. 0% 21. 7% 21. 5% 15. 0% 9. 2% 64. 0% 22. 3% 15. 0% 13

Ratios--projected Projected 2017 2018 2019 2020 2021 2022 after Ratios to calculate operating profit Sales growth rate 11. 0% 8. 0% 7. 0% 6. 0% COGS / Sales 62. 5% 63. 0% 64. 0% SGA / Sales 22. 5% 22. 5% Depreciation / Net PPE 15. 0% 15. 0% 14

Projecting operating capital • Cash – Reduce to 3% of sales from 2017 to 2019, then 2% in 2020 and thereafter. • Inventory – 11% of sales in 2017 and thereafter. • Accounts receivable – 7. 6% of sales in 2017 and thereafter. 15

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 2017. Will drop to 31. 5% and then to the average of 30. 8% by 2019. 16

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. 17

Historical Ratios to calculate operating capital Actual 2014 2015 2016 Average Cash/sales 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% 18

Ratios to calculate operating capital Projected 2017 2018 Cash / Sales 3. 0% Inventory/ Sales 11. 0% Accts. Rec. / Sales 7. 6% Net PPE / Sales 34. 0% 31. 5% Accts. Pay. / Sales 8. 1% Accruals / Sales 1. 0% 2019 3. 0% 11. 0% 7. 6% 30. 8% 8. 1% 1. 0% 2020 2. 0% 11. 0% 7. 6% 30. 8% 8. 1% 1. 0% 2021 2. 0% 11. 0% 7. 6% 30. 8% 8. 1% 1. 0% 2022 after 2. 0% 11. 0% 7. 6% 30. 8% 8. 1% 1. 0% 19

Projecting operating taxes • Taxes have averaged 39. 7% of pre-tax income, and are projected to remain there. 20

Dividend growth rate • Van Leer is stabilizing its historically erratic dividend policy. Growth for 2017 through 2020 is set at 10%. 2021 growth is projected to be 8%, and dividend growth is projected to be 6% thereafter. 21

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%. 22

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 shortterm debt to zero. 23

Historical Income Statement Net Sales Cost Of Goods Sold Selling, general & administrative Depreciation Operating profit Interest income Interest expense Earnings before taxes Taxes Net income Dividends Additions to RE Actual 2014 2015 2016 840. 0 944. 0 1, 000. 0 520. 0 625. 0 640. 0 200. 0 41. 0 79. 0 0. 0 9. 0 70. 0 28. 0 42. 0 12. 0 30. 0 205. 0 42. 0 72. 0 1. 0 9. 0 64. 0 25. 0 39. 0 11. 0 28. 0 215. 0 45. 0 100. 0 10. 0 90. 0 36. 0 54. 0 16. 0 38. 0 24

Projected Income Statement 2017 Net Sales 1, 110. 0 Cost Of Goods Sold 693. 8 SG&A 249. 8 Depreciation 56. 6 Operating profit 109. 9 0. 8 Interest income Interest expense 11. 2 Earnings before taxes 99. 5 Taxes 39. 5 Net income 60. 0 Dividends 17. 6 Additions to RE 42. 4 2018 2019 1, 198. 8 1, 282. 7 749. 3 801. 7 269. 7 288. 6 56. 6 59. 3 123. 2 133. 1 11. 9 8. 7 111. 2 124. 5 44. 2 49. 4 67. 1 75. 1 19. 4 21. 3 47. 7 53. 8 2020 2021 2022 1, 372. 5 1, 454. 9 1, 542. 1 864. 7 931. 1 987. 0 308. 8 327. 3 347. 0 63. 4 67. 2 71. 2 135. 6 129. 2 136. 9 0. 9 1. 9 2. 5 9. 1 9. 5 10. 1 127. 4 121. 6 129. 3 50. 6 48. 3 51. 3 76. 8 73. 3 78. 0 23. 4 25. 3 26. 8 53. 4 48. 0 51. 2 25

Historical Assets Cash Short- term investments Inventory Accounts receivable Total current assets Net PP&E Total assets Actual 2014 2015 2016 42. 0 47. 0 50. 0 15. 0 25. 0 75. 0 85. 0 100. 0 65. 0 70. 0 75. 0 192. 0 217. 0 250. 0 275. 0 280. 0 300. 0 467. 0 497. 0 550. 0 26

Projected Assets 2017 33. 3 Cash Short term investments 122. 1 Inventory 84. 4 Accounts receivable Total current assets 239. 8 377. 4 Net PP&E Total assets 617. 2 2018 36. 0 131. 9 91. 1 258. 9 377. 6 636. 6 2019 38. 5 30. 3 141. 1 97. 5 307. 3 395. 1 702. 4 2020 27. 5 63. 5 151. 0 104. 3 346. 3 422. 7 769. 0 2021 29. 1 83. 1 160. 0 110. 6 382. 8 448. 1 830. 8 2022 30. 8 104. 0 169. 6 117. 2 421. 7 475. 0 896. 7 27

Historical liabilities Accounts payable Accrued expenses Short-term debt Total current liabilities Long-term debt Total liabilities Common stock Retained earnings Total commonequity Total liabilities and equity Actual 2014 2015 2016 80. 0 75. 0 8. 0 10. 0 50. 0 30. 0 25. 0 138. 0 110. 0 54. 0 84. 0 99. 0 192. 0 194. 0 209. 0 125. 0 150. 0 178. 0 216. 0 275. 0 303. 0 341. 0 467. 0 497. 0 550. 0 28

Projected Liabilities 29

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? 30

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. 31

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? 32

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 33

Free Cash Flow Operating Income Tax on Operating Income NOPAT Net Operating WC Net Operating Long Term Assets Total Net Operating Capital Investment in net operating capital Free Cash Flow growth in FCF ROIC Actual 2014 2015 2016 79. 0 72. 0 100. 0 31. 6 28. 1 40. 0 47. 4 43. 9 60. 0 94. 0 122. 0 140. 0 275. 0 369. 0 280. 0 402. 0 300. 0 440. 0 33. 0 10. 88 38. 0 22. 00 102. 3% 11. 9% 14. 9% 34

Free Cash Flow Projected 2017 109. 9 43. 6 Operating Income Tax on Operating Income NOPAT 66. 3 138. 8 Net Operating WC Net Operating Long Term Assets 377. 4 Total Net Operating Capital 516. 2 Investment in net operating capital 76. 2 Free Cash Flow -9. 9 growth in FCF -144. 9% ROIC 15. 1% 2018 123. 2 48. 9 2019 133. 1 52. 9 2020 135. 6 53. 8 2021 129. 2 51. 3 2022 136. 9 54. 4 74. 3 149. 9 80. 3 81. 8 160. 3 157. 8 77. 9 167. 3 82. 6 177. 3 377. 6 395. 1 422. 7 448. 1 475. 0 527. 5 555. 4 580. 6 615. 4 652. 3 11. 3 27. 9 25. 2 34. 8 36. 9 63. 0 52. 3 56. 6 43. 1 45. 7 na -16. 9% 8. 2% -23. 9% 6. 0% 14. 4% 15. 2% 14. 7% 13. 4% 35

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%. r. S = r. RF + beta (RPM) = 6% + 1. 4 (5. 0%) = 13% 36

Cost of Capital… Target debt is 19. 8%, target equity is 80. 2% WACC = (1 -T)r. Dw. D + r. Sw. S = (1 - 0. 397)(9. 0%)(0. 198) + (13%)(0. 802) = 11. 5% 37

Valuation 2017 2018 2019 2020 2021 2022 Horizon Value 879. 80 Free Cash Flow (9. 89) 62. 95 52. 34 56. 61 43. 07 45. 65 FCF + Horizon Value (9. 89) 62. 95 52. 34 56. 61 43. 07 925. 45 38

Valuation • Present value at the WACC of 11. 5% is $622. 79 million. • This is as of the end of 2016 • Debt at end of 2016 is $124 million, shortterm investments are $25 million 39

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. 40