Laura Martin, a CSFB equity research analyst, delivers an innovative approach to valuation in a report on valuing Cox Communications. She posits that the analysis typically used in the cable industry is not exact. Rather, Martin introduces real options valuation which renders a higher value for Cox stocks. This case study allows students to compare and contrast various methodologies being used in valuations and how they are influenced by different factors. It also allows students to study how the changes in the industry affect which type of valuation method is appropriate.

Mihir A. Desai; Peter Tufano

Harvard Business Review (201004-PDF-ENG)

August 23, 2000

### Case questions answered:

- What function do equity analysts fulfill in a financial system? What constituencies do they serve? What are their incentives?
- Consider the multiples analysis developed in Exhibits 2, 5, & 6. What assumptions does this analysis rely upon?
- Consider the DCF analysis presented in Exhibit 7. How realistic are the assumptions?
- In what ways might the "stealth" tier be incorporated into the DCF analysis and multiples analysis? In what way is the stealth tier like a call option? What is the underlying asset? What is the strike price?
- Would you purchase Cox Communications on the basis of the analysis of Laura Martin?

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## Laura Martin: Real Options and the Cable Industry Case Answers

This case solution includes an Excel file with calculations.

### Multiples versus DCF analysis

Multiples analysis is simple to understand and apply. The inputs for the multiple are publicly available, though they are vulnerable to accounting manipulation. Also, it is difficult to obtain a truly comparable large sample of firms. Multiples analysis is backward-looking, reliant on historical/current data to obtain multiples. It reflects relative value rather than the intrinsic value which DCF valuation produces.

DCF analysis generates an intrinsic value as it relies on data specific to the firm. DCF analysis factors in time value of money, and thus is a forward-looking measure. However, there is uncertainty in forecasting future revenues, 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. The market, on average, prices these firms correctly, but makes errors on the pricing of individual stocks.

Exhibit 2 shows a selection of comparable firms, assuming that these firms have the same growth, risk, and return as Cox Communications. There is also the assumption that financial fundamentals such as EBITDA are defined identically in all firms, with the same accounting methods and reporting periods. Exhibit 5 assumes a positive linear relationship between ROIC and the multiple Adjusted Enterprise Value/Average Invested Capital.

### Regression analysis and traditional multiples analysis – similarities and differences

The two analyses both predict the underlying value of the firm. Also, both regression and multiples analyses reflect the past. The future value of the firm is obtained using historical inputs. Both analyses assume that firms in the same industry are comparable.

Traditional multiples analysis is more arithmetic in its approach. It is based on finding the average multiple among comparable firms and then applying it to the firm’s fundamentals. The accuracy of the valuation depends on the degree of comparability of the firms in the industry.

Regression analysis produces a statistical regression line of each comparable firm’s multiple against the fundamentals that affect the value of the multiple. The R-squared of the regression indicates how well that multiple works in the sector. After running the regression and establishing the multiple, then it is applied to fundamentals in order to arrive at a firm valuation price.

### Interpretation of regression results

Laura Martin’s regression results produced a higher share price of $50 (see A1), indicating that shares were currently undervalued and so Cox Communications does have growth potential.

Martin’s heavy reliance on the projection of the ROIC value is troubling. The 0.8% seems to be an arbitrary numerical projection. Any inaccuracy in this projection would result in…

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MBA student, Boston