Laura Martin: Real Options Valuation in the Cable Industry Case Questions

1.What is the nature of Laura Martin’s job? Define the specific problem that she is addressing.

A.Laura Martin is an equity research analyst. This was a unique opportunity to demonstrate her knowledge of the drivers of value in the cable industry. She was going to reveal the value of stocks of cable industry using real options, which is a more realistic way of evaluating the value of a project than EBITDA multiples, ROIC analysis and DCF analysis. In 1999 she presented at the Credit Suisse First Boston Broadband conference, where she wanted to portray the message that real options is a superior valuation technique for cable stocks.

The main reason why Laura Martin argues that real options is the correct method for valuing cable stocks is mainly driven by the evolution that this industry was experimenting. In this time period, cable companies were upgrading their cable infrastructure to have 750 MHz of bandwidth capacity, which left unused bandwidth capacity that could be used for other interactive services or services that didn’t exist at the moment. Laura Martin felt, and with reason, that the EBITDA multiplier and the DCF analysis did not account for this possible revenue stream which she named “Stealth Tier”. Her analyses led to a higher stock value using the real options method and lower values using the traditional methods aforementioned.

2.What methods does Laura consider in valuing the project? What are her reasons for choosing or rejecting each method? Does the data seem to support her point of view?

3.Identify the variables involved in the real options analysis. How will the value of each affect the acceptance decision?

4.Is Martin successful in presenting her approach to the valuation problem? Do you have suggestions for how she might have been more effective?

...LauraMartin: RealOptions and the CableIndustry
Introduction
LauraMartin, an equity research analyst for cable stocks, believes that the best way to value cable stocks is through creative methods such as realoptions and not through more traditional or typical valuation methods such as EBITDA multiples, ROIC analysis and DCF analysis. In 1999 she presented at the Credit Suisse First Boston Broadband conference, where she wanted to portray the message that realoptions is a superior valuation technique for cable stocks. She also wanted to have the opportunity to demonstrate her knowledge of the drivers of value in the cableindustry.
The main reason why LauraMartin argues that realoptions is the correct method for valuing cable stocks is mainly driven by the evolution that this industry was experimenting. In this time period, cable companies were upgrading their cable infrastructure to have 750 MHz of bandwidth capacity, which left unused bandwidth capacity that could be used for other interactive services or services that didn’t exist at the moment. Laura...

...Assignment #1 – LauraMartin: RealOptions and the CableIndustry
1. Consider the multiples analysis developed in Exhibits 2,5 & 6
Please describe the method of ‘Multiples’ using case numbers and answer to the following
questions:
1.1. What assumptions does this analysis rely upon?
1.2. How is Martin’s regression analysis different from/similar to traditional multiples analysis?
1.3. Do you agree with her interpretation of the regression analysis?
2. Consider the DCF analysis presented in Exhibit 7
Please describe the method of “Discounted Cash Flows” using case numbers and answer to the
following questions:
2.1. How reasonable are Martin’s forecasts for EBITDA and her assumptions about the asset intensity
of the business?
2.2. How plausible is Martin’s terminal value multiple?
2.3. What are the tradeoffs in using multiples versus the DCF analysis?
3. Realoptions
Please describe the method of “Realoptions” using case numbers and answer to the following
questions:
3.1. What is the analogy Martin is trying to draw with options? What is the “stealth tier”? What is the
unit of analysis? In what way is the stealth tier like a call option? What is the underlying asset price?
Strike price?...

...multiples. It reflectsrelative 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. DCFanalysis factors in time value of money, and thus is a forward-looking measure.However, there is uncertainty in forecasting future revenues, especially for privatefirms 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 arecomparable to the firm being valued. The market, on average, prices these firmscorrectly, but makes errors on the pricing of individual stocks. Exhibit 2 shows aselection of comparable firms, assuming that these firms have the same growth, riskand return as Cox Communications. There is also the assumption that financialfundamentals such as EBITDA are defined identically in all firms, with the sameaccounting methods and reporting periods. Exhibit 5 assumes a positive linearrelationship between ROIC and the multiple Adjusted Enterprise Value/AverageInvested Capital.
Regression analysis and traditional multiples analysis – similarities anddifferences
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...

...LauraMartincase study
Question 1- LauraMartin says she gets "paid to talk" - to whom is she talking?
Answer: LauraMartin is talking with investors. She would meet with many company representatives including the CEO, CFO, operating division chiefs and head of investor relations. She is in connections with these investors via telephone, fax, voice mail or email. It is approximately 900 individual per month.
Question 2- Given this crazy web of relationships, what are Martin's incentives? Can she anger the people who provide her information? What happens if she makes negative comments? Positive comments? When and how might she try to stand out from other analysts?
Answer:
Question 3- What is happening to the role Martin plays in the economy? Will people like Martin exist in 30 years?
Answer: People like Martin Exist in 30 years because each year “All-America Research Team” vote inverstors’ decision and Martin got high ratings among them which criterion evaluate on 10 points, industry knowledge 8.09 rating, written reports 7.26 rating, stock selection 7.20 rating, earnings estimates 6.83 rating and special services including company visits and conferances 6.70 rating. Therefore Martin thinks that “accesibility is important, I have to...

...FINS3625 APPLIED CORPORATE FINANCE
Case Study Written Report
Week 8 Valuation: LauraMartin
Name
Student Number
% Contributio n 20 20 20 20 20
Signature
Karen Chan Yifeng Chen (Nino) Tony Richardson Weitao Wu (Tony) Wendy (Wenyu) Yan
z3242429 z3283995 z3253113 z3284666 z3241580
1
Multiples versus DCF analysis Multiples analysis is simple to understand and apply. The inputs for the multiple are publicly available, though 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...

...
LauraMartin: RealOptions and the CableIndustry
Group 13
Adarsh N (60)
Gaurav Chand (82)
Hemant Kumar (83)
Prateek Gupta (99)
Rohan Gupta (104)
Sahil Jindal (105)
Individual Contribution: 16.67% for all group members
Strategic Financial Management
Prof. K . Sudershan
Ques 1. What is the role of LauraMartin? Consider the multiples analysis developed in Exhibits 2, 5 & 6. What assumptions does this analysis rely upon?
Role:
LauraMartin 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 cableindustry 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 realoptions analysis as she felt other valuation metrics...

...Question 1 What are the tradeoffs in using Multiples versus DCF analysis?
DCF Valuation
1. Forecast revenue for each year for from the firm’s financial data.
2. Select appropriate discount rate based on WACC
3. Discount each cashflow back to it present value
4. Obtain the terminal value through an application of terminal value multiple
5. You add these values together
6. Using this method, Martin calculates the price of Cox’s share to be $54.29
Multiple Valuation:
1. Identify comparable firms that have growth, cashflow and risks similar to those of target firm whose value is in question.
2. Obtain the individual multiple or ratio of the firm’s price to their financial data, such as EBITDA.
3. Average these multiples to obtain the industry average multiple.
4. Adjust this industry multiple and apply it to the target firm to get that firm’s value.
5. Using a multiple of 20.9, LauraMartin calculates the price of Cox’s share to be $50.00
Advantage of multiple
• With multiple, there’s no need to go through the process of forecasting future revenue with great uncertainty. It simply relies on current financial statement of comparable firms to obtain the industry average multiple.
• This process is simple to understand and easy to apply. As a result, the information is also cheap to obtain compared to the high cost of...

...Practice Questions-“RealOptions”
Some questions may require you to use financial calculator or Excel.
(In the final exam, for students without financial calculator, writing down the formula will be enough. However, those formulas must be correct to get full credit. Therefore, it is a good practice to check whether you are correct by using Excel for these practice questions)
1. How are realoptions different from financial options?
2. Consider the following project data:
(1) A $500 feasibility study will be conducted at t = 0.
(2) If the study indicates potential, the firm will spend $1,000 at t = 1 to build a prototype. The best estimate now is that there is an 80 percent chance that the study will indicate potential, and a 20 percent chance that it will not.
(3) If reaction to the prototype is good, the firm will spend $10,000 to build a production plant at t = 2. The best estimate now is that there is a 60 percent chance that the reaction to the prototype will be good, and a 40 percent chance that it will be poor.
(4) If the plant is built, there is a 50 percent chance of a t = 3 cash inflow of $16,000 and a 50 percent chance of a $13,000 cash inflow.
If the appropriate cost of capital is 10 percent, what is the project's expected NPV?
Answer : $35
To find the NPV of the first outcome:...

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