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Case Study Written Report

Week 8 Valuation: Laura Martin

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Karen Chan Yifeng Chen (Nino) Tony Richardson Weitao Wu (Tony) Wendy (Wenyu) Yan

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Exhibit 5 assumes a positive linear relationship between ROIC and the multiple Adjusted Enterprise Value/Average Invested Capital. prices these firms correctly. with the same accounting methods and reporting periods. DCF analysis factors in time value of money.Multiples versus DCF analysis Multiples analysis is simple to understand and apply. assuming that these firms have the same growth. Multiples analysis is backward-looking. both regression 2 . and thus is a forward-looking measure. DCF analysis generates an intrinsic value as it relies on data specific to the firm. risk and return as Cox Communications. on average. reliant on historical/current data to obtain multiples. Exhibit 2 shows a selection of comparable firms. though are vulnerable to accounting manipulation. Also. there is uncertainty in forecasting future revenues. However. It reflects relative value rather than the intrinsic value which DCF valuation produces. The inputs for the multiple are publicly available. The market. Regression analysis and traditional multiples analysis – similarities and differences The two analyses both predict the underlying value of the firm. especially for private firms and those firms that produce little or no cash flows. Assumptions of multiples analysis General assumptions of multiples analysis are that the other firms in the industry are comparable to the firm being valued. There is also the assumption that financial fundamentals such as EBITDA are defined identically in all firms. but makes errors on the pricing of individual stocks. it is difficult to obtain a truly comparable large sample of firms. Also.

Traditional multiples analysis is more arithmetic in its approach. indicating that shares were currently undervalued and so Cox Communications does have growth potential. The 0. after-tax cost of debt is 4. How accurate the valuation is depends on the degree of comparability of the firms in the industry. The linear relationship between ROIC and the multiple in the regression shows there is a strong relationship. Interpretation of regression results Martin’s regression results produced a higher share price of $50 (see A1).8% seems to be an arbitrary numerical projection. Martin’s DCF analysis Martin’s weighted cost of equity is 10.5%. Any inaccuracy in this projection would result in a misleading outcome. Regression analysis produces a statistical regression line of each comparable firm’s multiple against the fundamentals that affect the value of the multiple. then it is applied to fundamentals in order to arrive at a firm valuation price. However. The percentage variation in ROIC cannot be totally explained by the variation in Adj. After running the regression and establishing the multiple. R-squared is 70%. We have calculated the cost of equity to be 13.61% (see A2) using a levered beta and a risk premium calculated over a longer historical period. The future value of the firm is obtained using historical inputs. Both analyses assume that firms in the same industry are comparable. Using the synthetic rating method. Invested Capital. EV/Ave.51% 3 . It is based on finding the average multiple among comparable firms. Martin’s heavy reliance on the projection of the ROIC value is troubling. The Rsquared of the regression indicates how well that multiple works in the sector. it does tell us that ROICs are a substantive prediction of value. and then applying it to the firm’s fundamentals.and multiples analyses reflect the past.

53% the stock price becomes a more conservative $41. there are 17 unused channels (102 MHz).(see A3). Martin assumes an increase in capital spending in the first 2 years on new digital technology services. Both stable growth rates seem reasonable. but it also depends on the reliability of the EBITDA forecast.8% increase in ROIC as well as a forecasted growth in EBITDA of 16% and EBIT of 33%.02 and $33. Substituting the terminal value into the horizon value formula using a WACC of 9. it is unlikely that EBITDA will retain growth at a higher rate than revenue. Conducting sensitivity analysis with more conservative EBITA growth at 14% and 12% resulted in share prices of $37.2%. It allows the firm to calculate the intrinsic value of the underlying real project. Ways the “stealth tier” can be incorporated into DCF and multiples analysis 4 . to obtain revenues from the unused cable channels. DCF analysis does not account for these invisible but valuable revenue streams.53% results in a growth rate of 4. Martin has not taken into account the value of the empty cable channels.70 (see A4).49% respectively (see A7). But there is still 0. Martin’s projected EBITDA growth of 16% seems high since her forecasted revenue growth is only 14. resulting in a fall in asset intensity from 2003.4% and 7.46 respectively (see A6). Also. as FCF has been growing at a high rate (up to 474% in 2001). It gives the company the right. once other expenses are included. These forecasts seem contradictory. Real options analysis will also allow managers to adjust business strategies according to market situations. which is close to Martin’s estimate. So we can conclude that the terminal value of 13x is reasonable. and then a fall to a constant rate.3% and 12. Thus. but not the obligation. depending on market conditions. The real option within this project is the “stealth tier”. Real options valuation as an alternative to DCF analysis Of the 750 MHz capacity in an upgraded cable plant. unaccounted for in DCF analysis. with a WACC of 12. referred to as the “stealth tier”. Hence.

shows that the value of the stealth tier would increase the value per share that is produced by DCF analysis (see A8). and that the 14% premium on net value of the stealth tier per home passed of $341. Some issues retracting from the reliability of such analysis include the degree of judgement involved in the input estimates. An investment timing option could also be incorporated. especially in estimates of variance. which would allow Cox Communication to determine whether it would be profitable to “light up” and utilize the empty channels today or at a later date. Martin used the Black-Scholes model to value this stealth tier.65 is reliable. since B-S model assumes that options are exercised only at maturity. Therefore the decision of whether to use this capacity is a real option as the stealth tier has a value and a cost (see A11). How is the stealth tier like a call option? Applicability of Martin’s option analysis The stealth tier is similar to a call option as the company has the right but not the obligation to use the unused capacity to implement further operating capacity. Including the stealth tier option would impact the multiple analyses based on invested capital (see A10) and also EBITDA. and it is up to management as to it being exercised or not. Thus it appears that the B-S model can value the stealth tier due to it resemblance to a call option.A qualitative assessment of the real option. Inputs from the real option illustration can be obtained as required by the Black-Scholes model (see A12). The “stealth tier” could also be valued using decision-tree analysis (see A9). For an effective valuation however. Cox Communications would have to be compared to companies that have a similar stealth tier. which can be added to DCF analysis. Also. which is unrealistic. there may be 5 .

regression and DCF analysis don’t take into account the value of the stealth tier.8% increase in ROIC. There is growth potential for the firm. Cost of equity Martin’s rate is calculated based on 10-year risk-free rate.3/5376. Despite high estimated implied values. IC target multiple of 1. higher than the current price of $37. making it hard to predict the future beta. Applying this target multiple to fundamentals. all her valuation methods show that Cox Communications is currently underpriced. However.594.6)] = 1.54 6 . Martin assumed a 0. multiples. Conclusion Looking purely at Martin’s analyses. It is advisable that investors purchase Cox.50.07 [1 + (1 – 0. EV/Avg. and after adjustments were made. though a 10-year zero-bond would be preferable. Most analyses reveal that the stock is undervalued. This. APPENDIX A1.07 should be used to reflect the financial risk arising from debt. with new developments in digital technology services and use of spare capacity channels. [ A2. the levered beta is sensitive and fluctuates. The BS model using real option equivalent inputs results in a value of the stealth tier of $381. combined into the regression analysis.extra value from exercising the stealth tier before maturity. which is reasonable to reduce the uncertainty in forecasting 10 year EBITDA and free cash flows.65 per home passed which is at a 14% premium. bL = bU (1 + (1 – T)D/E) = 1. resulted in an estimate of the Adj.39)(3885.54 rather than an equity beta of 1. Martin arrived at an implied value of $50 for Cox’s share. A levered beta of 1.

Also. Cost of debt In terms of the cost of debt. the synthetic rating can be an alternative to work out the spread and then added to the risk-free rate.41% 11.51%.61% A3.09% The adjusted cost of equity then becomes 13.53% 5. with an after-tax cost of debt of 4. which is close to Martin’s estimate. Cost of equity= rf+ RP* βL = 5.30% 12.42% versus GR 7.67% GR 5.95 7 . calculated over a longer historical period should be used to reduce standard error.64% treasury Stocks versus Treasury Bonds AR 6.54 + 5.51% 4. Interest coverage ratio = operating income/ interest expense = 659.12% = 13.61%.3 = 2.25% 7. Stocks bills AR 19282000 19622000 19902000 8.51%.52% 7.1/223.41% 6. a risk premium of 5.51% x 1.17% 5.

99.4x0.53% Thus. WACC = [13.2x___ + 1.133 >4.2286 + 3.39) =4. A4.99. Z=1. 8 .5 / 12878.Hence the Cox Communication is within BBB rating with spread 2.0X5 X1 = Working capital/total assets = ? X2 = Retained earnings/total assets = 2944.50% x 3800/(28260+3800)] = 12.81 and Z > 2.8/12878.2286 X3 = EBIT/total assets = 201/12878.3= 7.15 X5 = Sales/total assets =1716. even with an unknown X1.25% + 5.133 Z= 1.3 x 0.2X1 + 1. we evaluate the riskiness of Cox Communications.1 = 0.15 + 1 x 0.12%) x (1-0.1=0. the Z-score is greater than 2.4X2 + 3.51% Using a credit scoring model.6X4 + 1. with a WACC of 12. This indicates that Cox Communications is pretty safe. Therefore.1 = 0.53% the stock price becomes a more conservative $41.25% After-tax cost of debt = (2.016 + 0.70.796 Critical values of Z < 1. the Altman Z Score Model.61% x 28260/(28260+3800)] + [4.6 x 7.3X3 + 0.016 X4 = Market value equity/book value LT debt = 21195/3885.

5% 286.015 16.9% 461.6% 495.2% -1% 28% -100 -104 -123 -168 -237 -315 -402 -502 -615 -744 -893 24% 458 -978 -419 607 -1040 -343.19479 43 569 -261 1131.8% 514.411 72 549 -261 1322.015 57.9% 533.005 16.70 $37.08578 35 591 -261 970.01 16.7% 478.7 2008 2958 -515 2443 108.05866 58 -1% 12% -419 3845 4 Value 2844.87897 32 616 -261 832 80.3 2006 2198 -549 1649 108.99 5 16.6 2005 1895 -569 1326 108.8% 40.96773 97 515 -261 1804.07% 50.53% Terminal Value of 2008E Total EBITDA Equity Valuation Analysis 199 8 659 -458 201 84.14999 02 531 -261 1545.1 2000 924 -680 244 107.1 2003 1408 -616 792 108 2004 1634 -591 1043 105.2 $41.Year EBITDA Less: Depn and Amort EBIT amortization Less: Taxes(EBIT+A mortization at 35%) Plus: Depreciation and Amortization Less: Capex FCF growth PV of FCF @ WACC 12.6829 29 680 -750 51.2 2001 1047 -674 373 107 2002 1214 -644 570 107.7 1999 800 -607 193 104.50 PV of Unlevered FCF PV of TV discounted to 1999 6 .4 CACG 16.7% 204.319 683 11810.985 21.91695 55 644 -517 460.337989 71 674 -587 292 471.8% 305.8% 554.08 114.1 2007 2550 -531 2019 106.99 16.22 94 % DCF 12.11% Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) 565.

53% 7 .20% Terminal Multiple 13.12% 0.10% 52.54 908 -16. PMV Other Assets.15% 1.70% 100.(Long term Debt at 12/21/99E) Cash at 12/31/99E Non-Consolidated Assets.00 WACC 12. PMV Discounted Cash Flow Value -3800 23 12292 400 23569.00% Discount to DCF Value Price Appreciation to DCF 10.07% 11.

8390 -569 887.51683 24 569 -261 847.98255 4 531 -261 1075.4589 106.7% 372.6496 107.1 2003 1161.2 2001 925.632598 22 674 -587 213.3% 370.6496 -680 146.08 -607 131.700 08 12. Year EBITDA Less: Depn and Amort EBIT amortization Less: Taxes(EBIT+A mortization at 35%) Plus: Depreciation and Amortization Less: Capex FCF growth PV of FCF @ WACC 12.4 CACG 12.8476 107 2002 1036.89382 66 12.37694 72 12.383 2 -616 545.7% 515 -261 1211.754 0 -515 1531.3532 86 12.4589 -531 1296.1 2007 1827.4493 91 680 -750 12.1447 94 -1% 12% -419 371.19776 108.1 2000 826.7 1999 738.65185 26607.53% Terminal Value of 2008E Total 1998 659 -458 201 84.25090 88 -1848.93201 79 61.7% 372.6 2005 1456.6597 -549 1082.76846 08 549 -261 953.8016 8 .7 2008 2046.7% 215.0% -1% 23% -100 -82 -89 -126 -175 -229 -285 -349 -417 -491 -574 19% 458 -978 -419 607 -1040 -384.19038 09 12.A6.754 0 108.6990 6 94.2486 62 591 -261 754.65317 5 644 -517 344.8476 -674 251.8390 108.233 9.7491 -591 709.7491 105.3832 108 2004 1300.1% 9.6% 370.3% 371.6597 108.0% 341.10981 8 616 -261 671.9493 -644 392.3 2006 1631.3% 149.9493 107.08 104.

2 $33.4870 2005 1648.951 96 -3800 23 12292 400 18910.21% -20.0% -1% 25% 9 .26 2000 856.12% 65.EBITDA Equity Valuation Analysis PV of Unlevered FCF PV of TV discounted to 1999 (Long term Debt at 12/21/99E) Cash at 12/31/99E Non-Consolidated Assets.50 -12.00% Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) Discount to DCF Value Price Appreciation to DCF 565.0341 -531 1612.0341 2008 2443.995 1 -569 1079.53% Year EBITDA Less: Depn and Amort EBIT 1998 659 -458 201 1999 751.024 7 -644 469.995 2006 1879.08% -10.00% 2.8482 2004 1446.3375 2002 1113.4364 2001 976.94 612 % DCF 9.487 0 -591 855.12% 100.26 -607 144.854 5 -549 1330.09% 0. PMV Discounted Cash Flow Value Value 1823. PMV Other Assets.65% 43.058 8 -515 1928.78% Terminal Multiple 13.00 WACC 12.058 CACG 14.4364 -680 176.8482 -616 652.46 $37.994 156 8171.0247 2003 1268.854 2007 2143.3375 -674 302.

3 5 108.0% 172.4 -100 458 -978 -419 -87 607 -1040 -375.00% Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) Discount to DCF Value Price Appreciation to DCF 565.5% 418.7% 433.1 107.765 Equity Valuation Analysis PV of Unlevered FCF PV of TV discounted to 1999 (Long term Debt at 12/21/99E) Cash at 12/31/99E Non-Consolidated Assets.54451 5 -713 515 -261 1469.2 $37.2 107 107.5% 425.8363 10 -99 680 -750 7.2599 31 22% -1% 12% -419 31759.16366 111.4771 5 14.0693 72 3335. PMV Other Assets.1065 24 14.8% 442.62% -18.3% 245.6842 01 -202 644 -517 394.7 8 108.53% Terminal Value of 2008E Total EBITDA 84.5% 333.4309 33 -504 549 -261 1115.0% 410.7% 451.55133 6 88.542 33 9754.6 108.1 106.3810 85 60.02 $37.657158 25 -143 674 -587 246.220 39 14.77% 46.11% 58.7246 97 -602 531 -261 1280.666 11.96007 1 -336 591 -261 849.1694 1 -416 569 -261 972.7 104.75% 1.28% 10 .3% 5.30% -1.50 -1.298 2 14. PMV Discounted Cash Flow Value Value 2253.9477 20 -266 616 -261 741.79 703 % DCF 10.1 amortization Less: Taxes(EBIT+Amorti zation at 35%) Plus: Depreciation and Amortization Less: Capex FCF growth PV of FCF @ WACC 12.1 108 105.91% 100.0918 37 14.254 7 -3800 23 12292 400 20922.16% 0.

53% 11 .00 WACC 12.Terminal Multiple 13.

g) With Laura Martin’s WACC of 9.454 = 1804(1 +g)/(12. Cash flows for the next 10 years generated under the stealth tier can be projected under different market condition scenarios. which adds value as the holder of the option has a longer time to decide action. the riskier the underlying. Volatility of 50% is high.g) g = 4.53% . the option has an estimated 10 year life.454 = 1804(1 +g)/(9. the more valuable the option. adding value to the option. Horizon Value Formula: With our calculated WACC of 12.A7. In addition. Finally for this scenario. Considering that the current price (or value of the option) is calculated as $23.15 per channel/per home. and the exercise price is $1.22 (opportunity cost of profit passed) the option is valuable (the current price is significantly larger than the exercise price). A9. The cash flows under each scenario can then be discounted back to the current time.53% : TV = FCF(1+g)/(WACC – g) $38.3% TV = FCF(1+g)/(WACC – g) $38.4% g = 7. and the weighted average calculated to arrive at expected NPV of the tier” the “stealth 9 .3% .49% A8.

Based on the calculations the driver of enterprise value is the return on invested capital (ROIC).e. This means that for the company.08976/17 x 15 = 7. the stealth tier has a potential value (i.08976/17 x 5 = 2.66 = 0.102MHz/750MHz = 13.22 $23.08976 With 15 channels: With 10 channels: 0.25% 10 years $1.92% 0. as EBITDA increases therefore increasing the return that is used when calculating ROIC. value of the 17 channel “stealth tier” is 0. A12.64% A10. value per channel times number of channels) and a strike price (which in this case is likened to the opportunity cost of profit forgone if the project is not implemented). ROIC would increase should the real option be exercised.6% unused 750MHz cable plants Only 66% of plant will be upgraded to 750MHz. So.28% With 5 channels: 0.15 50% It is estimated that the current value per channel for the stealth tier is $23. A11.08976/17 x 10 = 5.15. This 10 . Black-Scholes Model Inputs Risk-free rate Time until option expires Strike price Current price of stock Variance Real Option 5.136 x 0.

9192) =0. to light up one channel.5^2)/2]10} / (0.99)-N(2.15.403 N(d1)= N(2. John Wiley & Sons.9986-0.3 (N(1.98) +0.22) + [0.i. 11 .9986) =0.9986) . Damodaran. In this case.9207-0. if the channels are lit.984) = N(2. so opportunity cost of foregone profit is used.9986 N(d2)=N(1. P.46 BIBLIOGRAPHY 1. there is an opportunity cost profit of $1.e.41)-N(1.40)) =0. E. (2002) Investment Valuation: Tools and Techniques for Determining the Value of Any Asset.403) = N(1.9192 +0.4 (0. per home passed.5√10 = 1. Brigham. Inc. i.5√10) = 2.91965 C = 23. (2010) Intermediate Financial Management. Entering the relevant figures into the BS model: d1 = {ln(23.984 d2 = d1 – 0.22 per channel.4( N(2. there is no actual cost to be incurred as the capacity is already there.0525 + (0.is based on calculations using the currently implemented channels and is the current value because it signifies the value that Cox Communications could receive should one of the stealth channels be used.3 (0. A.e.22*0.4) +0. and Daves.98)) =0.9986 +0.1. The strike price is the cost for Cox Communications to acquire the asset worth $23.91965*e^(-0. SouthWestern Cengage Learning.15 (0.15/1. 2.0539*10) = 22.

A.3. 12 . Saunders. et al (2007) Financial Institutions Management. McGraw-Hill.

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