LAURA MARTIN:REAL OPTIONS

AND THE CABLES INDUSTRY

Group 7
Q.1 What function do equity analysts fulfil in a financial system? What constituencies do
they serve? What are their incentives?
Ans. Equity analysts focus on the stocks of companies—the equity portion of the capital
structure. Basic work includes financial modelling and analysis, focused on a sector or group of
companies. Their deliverables include reports, projections, and recommendations concerning
companies and stocks.
Buy side – Work for money management firms (fund managers at mutual fund brokers and
financial advisory firms)
• Reports produced by them are for the use of firms that employ them and not shared
outside
Sell side – Work for a broker dealer that distribute or sell the research to the buy side client
• They often work for the big investment banks. Their jobs entail researching the financial
fundamentals of companies the bank is considering taking public and determining which
ones have the strongest potential to become profitable
Incentive: Exposure to C-suite executives, diverse industry exposure, client communication (get
paid to talk) and lucrative compensation

Q.2 Consider the multiples analysis developed in Exhibits 2, 5, & 6 What assumptions does
this analysis rely upon?
Overview of Exhibits 2 and 6
• Exhibit 2 shows the financial summary for selected comparable companies. In particular, it
shows the first few steps of multiple analysis, the calculation of industry average multiple
using comparable firms.
• Exhibit 6 shows the target share price, EBIDTA value and various other equity data for Cox.
In particular it shows the last few steps of multiple analysis, namely the application of
industry average multiple to Cox, in order to arrive at its target price of $50.00
• When combined, the exhibit 2 and 6 demonstrates the complete process of traditional
multiple analysis via EBITDA.

Assumptions:
• Exhibit 2 shows selection of firms based on industry. It assumes that these firms have the
same growth, risk and return as the target firm. In reality, these fundamental variables differ
from firm to firm even in the same industry.
• There is the definitional assumption. Analysts assume that their definition of EBIDTA is
uniform with others. But in reality this is not true. In exhibit 2, Martin defined the multiple
to be Implied Cable value + Non Cable Consolidated Assets/adjusted EBIDTA. A different
definition may be used in another industry. This inconsistency in definition may open
multiple analysis to manipulation by analysts to fit their particular figures.
• There is also an assumption that comparable firms calculate their EBIDTA with the same
timing. In reality, this might not be the case. Cox communication might start their fiscal year
at a different time to Adelphia communication. The EBIDTA value might reflect different
seasonal demands at different times of the year. But since they are assumed to be the same, it
once again exposes EBIDTA value to errors.
• The fundamental assumption here is the reliance on EBIDTA as a multiple as opposed to
other multiples such as price to earnings ratio. EBIDTA tracks the trend of profitability
independent of the company’s capital structure and tax position.
• Reliance on this figure may cause fundamental flaw to the value achieved as significant
factors are ignored. For instance it ignores the necessity of spending to replace the
depreciating equipment. It assumes that companies would finance 100% of their capital
expenditure externally.

Exhibit 5 and its assumptions:

Q.3 Consider the DCF analysis presented in Exhibit 7. How realistic are the assumptions?
Single WACC of 9.3%: In DCF analysis the NPV is calculated as the present value of the future
net free cash flows (revenue) less the present value of the costs (expense). Usually they are both
discounted at the companies WACC. This is a flawed assumption and an assumption also made
by Laura Martin in reality the free cash flows depend on the on market demand, market prices
and other external market factors and the market only compensates the firm for taking on
markets risks. While costs depend on internal private risks meaning that the costs should be
discounted at a different rate (Usually at a rate slightly higher than the risk free rate).
Discounting the costs and cash flows at the same rate will reduce the costs significantly, hence
overvaluing the firm.
Beta: In calculating WACC Laura Martin used a beta. The problem with beta is that it is a
sensitivity factor measuring co-movements of a firm’s equity prices of 1.07 to forecast 10 years
of cash flows with respect to the market. The problem is that equity prices change every few
minutes depending on the time frame used for the calculation, beta might fluctuate widely.
EBITDA Forecast: Forecasting cash flows in the future is often very difficult and may require
econometric techniques, such as Monte Carlo simulation, and there are areas of error with each
forecast compounding. i.e. forecasting depreciation and amortization, capital spending and
investments. 10 years is also a very long time to forecast, i.e. refer to the pie graph, which shows
the change in subscription demands, so how can she accurately project into the future, although
she did incorporate technological shifts, emerging industry structures and value drivers into her
analysis, these are again very difficult to predict, and thus her EBITDA forecasts are reasonable
to a certain extent.
Asset Intensity: Asset intensity is defined as the value of assets required by a business to
support $1 in sales. Martin creates false assumption of asset intensity, as the company is being
hit for 100% of the capital spending but only visible revenue streams from existing services are
accounted.
Terminal Value Multiple: Terminal Multiple Approach assumes the firm will be sold at the end
of the forecast period. Firms with comparable acquisitions are used to find an appropriate range
of multiples to use. Market-driven analytics result in a terminal value with a significant level of
confidence that the valuation accurately depicts how the market would value the company in
reality. The multiple itself is quite plausible. The problem is that there is no firm which is
comparable to COX since there is no firm valuing the stealth tier. The terminal value found by
the terminal multiple which still needs to be discounted by problematic WACC as discussed
earlier.

Q.4 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?
DCF Analysis
This unused cable capacity could be incorporated into the DCF Analysis by deriving the
potential cash flows that could be achieved from the stealth tier. A report produced by Credit
Suisse First Boston, valued the unused capacity to range between $13 and $169 per home passed.
Using a decision tree approach, and taking $13 per home passed to equal the Low Value, with a
probability of 25% occurrence, and similarly Median and High Value of $80 and $169 per home
passed, 50% and 25% respectively. Using the Discount Cash Flow Method, and by applying the
appropriate probabilities, you will arrive at an expected value which you will then discount back
to time zero.
Multiples Analysis
Assume that the comparable companies have a stealth tier, then all the values would have
increased, or similarly find firms that have incorporated a stealth tier into their valuation. This
would be an unrealistic assumption as there may not be any companies available for comparison
which meets these characteristics, and thus is flawed.
How is the Stealth Tier like a Call Option?
The stealth tier is like a call option because it provides the right to use it but not the obligation
for existing users of the cable bandwidth. If the value of the bandwidth exceeds the cost of the
portion of the stealth tier, then they will light up and use their band width and use it for new
technology. But if the cost exceeds it, then they will not use it, which is similar to letting the
option expire and thus the holder of the option would have just incurred the cost of the option,
i.e. the premium price.
The underlying asset in this case would be the cash flows associated with the stealth tier and the
strike price would be the cost to develop the technology for the realization of revenue through
the Stealth Tier

Q.5 Would you purchase Cox Communications on the basis of her analysis?
Ans. Cable Industry is going through rapid and tremendous change. From exhibit 8, we can
notice a significant structural change from predominantly analog video-based subscribers to a
much more diversified consumer base. Martin’s analysis captures the unused bandwidth
capacity, “Stealth Tier” and its translation into cash flows for the company. Real option approach
unearths the revenues from potential new services which other methods fail to capture. Intrinsic
value of real option translated to 14% premium to the current market valuation per home passed
and a call option per home passed $22.45. This value isn’t captured in other mode of analysis for
an industry going through a significant transformation and that’s why it makes sense to purchase
given that the stock is currently undervalued.