Case Study - Laura Martin is a sellside equity analyst at CSFB. She covers 15 large capitalization stocks and focuses on 2 industries.

by prateekgupta235gmailcom (student)

University Degree Business and Administrative studies

Ques 1. What is the role of Laura Martin? Consider the multiples analysis developed in Exhibits 2, 5 & 6. What assumptions does this analysis rely upon?

Role:

Laura Martin is a sell-side equity analyst at CSFB. She covers 15 large capitalization stocks and focuses on 2 industries. Martin estimated that she spent approximately 40% of her time analysing firms she covered, 35% communicating that analysis to buy-side clients and 25% on internal CSFB activities.

Martin has covered the cable industry for the last 5 years. During that time, she had tried to differentiate herself from her competitors through an emphasis on more advanced valuation techniques. While most of her competitors were content with metrics such as EBITDA multiples, Martin had chosen to emphasize discounted cash flow analyses and EVA analyses. Recently, her attention had shifted to real options analysis as she felt other valuation metrics neglected an important aspect of the cable industry.

ROIC Target Price Analysis

Using regression analysis, Martin analysed the relationship between ROIC and the valuation of cable and entertainment companies as defined by the ratio of enterprise value to average invested capital. Martin projected that Cox would improve its ROIC by 0.8% or 80 basis points, in 1999. Martin then used the regression line to estimate the target enterprise value to average invested capital multiple. Adjusted for non-consolidated assets, other assets, cash and option proceeds and debt, Martin inferred a target price for Cox by year-end 1999 of $50. This ROIC “Target Price” Analysis indicated to Martin that Cox had significant upside potential relative to its current stock price of $37.50.

EBITDA Multiples Analysis

The valuation of Cox Communications has been framed by Martin in the form of EBITDA multiples since it is a common metric in the cable business.

In Exhibit 6, Martin compares how Cox currently traded as a multiple of EBITDA relative to how it would trade if Martin’s target process of $50 and her projections for EBITDA would be realized. According to this analysis, Cox currently traded at 13.3X EBITDA and Martin’s target price would translate into a 20.9X EBITDA multiple for 1999.

This analysis reflected only the past figures and doesn’t account for ...

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EBITDA Multiples Analysis

The valuation of Cox Communications has been framed by Martin in the form of EBITDA multiples since it is a common metric in the cable business.

This analysis reflected only the past figures and doesn’t account for different accounting practices. A dynamic industry makes it difficult to find comparable firms for valuation using multiples.

Ques 2. Consider the DCF analysis presented in Exhibit 7. Based on the case contents, comment on how realistic the assumptions are, justify?

From the DCF analysis presented in Exhibit 7, we see that the value of Cox Communications comes out to be $54.29 per share which presents a 31% upside in the stock based on the current price. This is a very high stock valuation so we need to look into the assumptions made while calculating the DCF value.

EBITDA growth rate has been assumed to be a highly optimistic estimate of 16% CAGR for the next 10 years.
Perpetual growth rate of 4.4% has been assumed which is a realistic assumption.
Concern over CAPEX decreasing as capital will depreciate to nothing over time.
The capital structure remains unchanged at 18% debt to capital ratio. Risk free rate has increased to 5.359% from 5.12% so the cost of equity is raised to 10.69% and the WACC increases to 9.42%
Martin was too optimistic in her assumptions. If we do the DCF using our inputs then we find that the value comes out to be $41.10 per share which is a 9.6% premium over the market price.

Ques 3. Why is Martin pushing real options valuation as an alternative to DCF analysis?

Martin felt that discounted cash flow analysis was a significantly better valuation toll than EBITDA multiples but it had several shortcomings in the new digital world of the cable industry in particular; Martin noted that the previous analysis did not include the value from unused bandwidth capacity.

Martin considered the DCF valuation unsatisfactory for these unused channels because companies are being hit for 100% of the capital spending but only the visible revenue streams from the existing services are being counted for the DCF valuation. Since the stock price of Cox was below the DCF valuation and since the DCF valuation did not incorporate the value of the stealth tier, Martin reasoned that the stealth tier was actually being ignored by the market.

Thus Martin felt that by incorporating the Real options valuation in her investment thesis she could differentiate herself from her competitors and provide better value to her clients.

Ques 4. What is the analogy Martin is trying to draw with options? What is the ‘stealth tier’? In what way is the stealth tier like a call option? What is the unit of analysis? What is the underlying asset price? What is the Strike price and Volatility?

Martin turned to real options to value ‘stealth tier’ since she considered the stealth tier as a real option for cable companies such as Cox as they could potentially light up the stealth tier as new, currently immature or unknown interactive services were developed. According to Martin, the contingent nature of investment decision and the uncertainty surrounding the ultimate revenue streams made the stealth tier ideal for valuation through real option analysis. As financial options give holders the right, but not obligation, to buy securities, this real option gave each upgraded cable company the right, but not the obligation, to obtain revenues from the stealth tier, depending on market conditions. Real option analysis has been used in several industry settings including natural resources extraction and pharmaceuticals research.

Cable companies were upgrading cable infra to have 750 MHz of bandwidth and additional 15% to 550 MHz by June 1999. Out of the 750 MHz of capacity in an upgraded cable plant, 550 MHz was typically devoted to analog video and another 98 MHz was dedicated to digital services, network control, telephony and internet services. The remaining 102 MHz comprised of 6 MHz channels and was essentially unused. This unused capacity of 102 MHz was called stealth tier as the revenue streams were invisible.

In order conduct a real options valuation of stealth tier, Martin considered the best approach was to value the option of each channel of the stealth tier per home passed. Martin used the average current market value per home passed for a typical cable company of $2,500 which was further divided by 108 lit channels currently being employed to yield a current value of channel per home passed of $23.15 which is the value of underlying asset (Exhibit 10).

For strike price, she calculated the cost of light up one of the seventeenth channels of the stealth tier which was coming close to zero. She eventually considered the higher opportunity cost of not lighting up the fiber immediately. With 61% penetration rate, implied annual revenue of $263 or $2.44 ($263/108 channel) per channel translated into $1.22 (cable industry margin of 50%) of foregone annual profit per channel per home passed which is the strike price.

She used implied volatility from a traded at-the-money call option on the Cox stock to estimate the relevant volatility for the real option. A one-month call option traded in the market was priced to imply a volatility of 50% per year.

Ques 5. Would you purchase Cox Communications on the basis of her analysis?

Investment recommendation will be to buy Cox Communications since there is significant upside potential in the stock even with our conservative estimate.