Fin361 Week 5 Regression Analysis Case
FINS3625 APPLIED CORPORATE FINANCE
Case Study Written Report
Week 8 Valuation: Laura Martin
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. …show more content…
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 2
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. How accurate the valuation is 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 Rsquared 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 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 a misleading outcome. R-squared is 70%. The percentage variation in ROIC cannot be totally explained by the variation in Adj. EV/Ave. Invested Capital. However, it does tell us that ROICs are a substantive prediction of value. The linear relationship between ROIC and the multiple in the regression shows there is a strong relationship. Martin’s DCF analysis Martin’s weighted cost of equity is 10.5%. 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. Using the synthetic rating method, after-tax cost of debt is 4.51% 3
(see A3), which is close to Martin’s estimate. Thus, with a WACC of 12.53% the stock price becomes a more conservative $41.70 (see A4). Martin’s projected EBITDA growth of 16% seems high since her forecasted revenue growth is only 14.2%. Hence, once other expenses are included, 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 $37.02 and $33.46 respectively (see A6). Martin assumes an increase in capital spending in the first 2 years on new digital technology services, and then a fall to a constant rate, resulting in a fall in asset intensity from 2003. But there is still 0.8% increase in ROIC as well as a forecasted growth in EBITDA of 16% and EBIT of 33%. These forecasts seem contradictory. Also, Martin has not taken into account the value of the empty cable channels. Substituting the terminal value into the horizon value formula using a WACC of 9.3% and 12.53% results in a growth rate of 4.4% and 7.49% respectively (see A7). Both stable growth rates seem reasonable, as FCF has been growing at a high rate (up to 474% in 2001). So we can conclude that the terminal value of 13x is reasonable, but it also depends on the reliability of the EBITDA forecast. Real options valuation as an alternative to DCF analysis Of the 750 MHz capacity in an upgraded cable plant, there are 17 unused channels (102 MHz), referred to as the “stealth tier”. DCF analysis does not account for these invisible but valuable revenue streams. The real option within this project is the “stealth tier”. It gives the company the right, but not the obligation, to obtain revenues from the unused cable channels, depending on market conditions. It allows the firm to calculate the intrinsic value of the underlying real project, unaccounted for in DCF analysis. Real options analysis will also allow managers to adjust business strategies according to market situations. Ways the “stealth tier” can be incorporated into DCF and multiples analysis 4
A qualitative assessment of the real option, which can be added to DCF analysis, shows that the value of the stealth tier would increase the value per share that is produced by DCF analysis (see A8).
The “stealth tier” could also be valued using decision-tree analysis (see A9). An investment timing option could also be incorporated, 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. Including the stealth tier option would impact the multiple analyses based on invested capital (see A10) and also EBITDA. For an effective valuation however, Cox Communications would have to be compared to companies that have a similar stealth tier, which is unrealistic. 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. 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), and it is up to management as to it being exercised or not. Martin used the Black-Scholes model to value this stealth tier. Inputs from the real option illustration can be obtained as required by the Black-Scholes model (see A12). Thus it appears that the B-S model can value the stealth tier due to it resemblance to a call option, and that the 14% premium on …show more content…
net value of the stealth tier per home passed of $341.65 is reliable. Some issues retracting from the reliability of such analysis include the degree of judgement involved in the input estimates, especially in estimates of variance. Also, since B-S model assumes that options are exercised only at maturity, there may be 5
extra value from exercising the stealth tier before maturity. Conclusion Looking purely at Martin’s analyses, all her valuation methods show that Cox Communications is currently underpriced. Despite high estimated implied values, multiples, regression and DCF analysis don’t take into account the value of the stealth tier. The BS model using real option equivalent inputs results in a value of the stealth tier of $381.65 per home passed which is at a 14% premium. It is advisable that investors purchase Cox. Most analyses reveal that the stock is undervalued. There is growth potential for the firm, with new developments in digital technology services and use of spare capacity channels. APPENDIX A1. Martin assumed a 0.8% increase in ROIC. This, combined into the regression analysis, resulted in an estimate of the Adj. EV/Avg. IC target multiple of 1.594. Applying this target multiple to fundamentals, and after adjustments were made, Martin arrived at an implied value of $50 for Cox’s share, higher than the current price of $37.50. [ A2. Cost of equity Martin’s rate is calculated based on 10-year risk-free rate, which is reasonable to reduce the uncertainty in forecasting 10 year EBITDA and free cash flows, though a 10-year zero-bond would be preferable. A levered beta of 1.54 rather than an equity beta of 1.07 should be used to reflect the financial risk arising from debt. However, the levered beta is sensitive and fluctuates, making it hard to predict the future beta. bL = bU (1 + (1 – T)D/E) = 1.07 [1 + (1 – 0.39)(3885.3/5376.6)] = 1.54
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Also, a risk premium of 5.51%, calculated over a longer historical period should be used to reduce standard error. Stocks bills AR 19282000 19622000 19902000 8.41% 6.41% 11.42% versus GR 7.17% 5.25% 7.64% treasury Stocks versus Treasury Bonds AR 6.53% 5.30% 12.67% GR 5.51% 4.52% 7.09%
The adjusted cost of equity then becomes 13.61%. Cost of equity= rf+ RP* βL = 5.51% x 1.54 + 5.12% = 13.61%
A3. 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, with an after-tax cost of debt of 4.51%, which is close to Martin’s estimate. Interest coverage ratio = operating income/ interest expense = 659.1/223.3 = 2.95 7
Hence the Cox Communication is within BBB rating with spread 2.25% After-tax cost of debt = (2.25% + 5.12%) x (1-0.39) =4.51% Using a credit scoring model, the Altman Z Score Model, we evaluate the riskiness of Cox Communications. Z=1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 X1 = Working capital/total assets = ? X2 = Retained earnings/total assets = 2944.5 / 12878.1 = 0.2286 X3 = EBIT/total assets = 201/12878.1 = 0.016 X4 = Market value equity/book value LT debt = 21195/3885.3= 7.15 X5 = Sales/total assets =1716.8/12878.1=0.133 Z= 1.2x___ + 1.4x0.2286 + 3.3 x 0.016 + 0.6 x 7.15 + 1 x 0.133 >4.796 Critical values of Z < 1.81 and Z > 2.99. Therefore, even with an unknown X1, the Z-score is greater than 2.99. This indicates that Cox Communications is pretty safe.
A4. WACC = [13.61% x 28260/(28260+3800)] + [4.50% x 3800/(28260+3800)] = 12.53% Thus, with a WACC of 12.53% the stock price becomes a more conservative $41.70.
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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 12.53% Terminal Value of 2008E Total EBITDA Equity Valuation Analysis
199 8 659 -458 201 84.7
1999 800 -607 193 104.1
2000 924 -680 244 107.2
2001 1047 -674 373 107
2002 1214 -644 570 107.1
2003 1408 -616 792 108
2004 1634 -591 1043 105.6
2005 1895 -569 1326 108.3
2006 2198 -549 1649 108.1
2007 2550 -531 2019 106.7
2008 2958 -515 2443 108.4
CACG 16.2% -1% 28%
-100
-104
-123
-168
-237
-315
-402
-502
-615
-744
-893
24%
458 -978 -419
607 -1040 -343.985 21.8% 305.6829 29
680 -750 51.08 114.8% 40.337989 71
674 -587 292 471.7% 204.91695 55
644 -517 460.015 57.5% 286.87897 32
616 -261 832 80.9% 461.08578 35
591 -261 970.99 16.7% 478.19479 43
569 -261 1131.99 5 16.6% 495.411 72
549 -261 1322.015 16.8% 514.14999 02
531 -261 1545.005 16.9% 533.96773 97
515 -261 1804.01 16.8% 554.05866 58
-1% 12%
-419
3845 4 Value 2844.319 683 11810.22 94 % DCF 12.07% 50.11% Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) 565.2 $41.70 $37.50
PV of Unlevered FCF PV of TV discounted to 1999
6
(Long term Debt at 12/21/99E) Cash at 12/31/99E Non-Consolidated Assets, PMV Other Assets, PMV Discounted Cash Flow Value
-3800 23 12292 400 23569.54 908
-16.12% 0.10% 52.15% 1.70% 100.00%
Discount to DCF Value Price Appreciation to DCF
10.07% 11.20%
Terminal Multiple
13.00
WACC
12.53%
7
A6.
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 12.53% Terminal Value of 2008E Total 1998 659 -458 201 84.7 1999 738.08 -607 131.08 104.1 2000 826.6496 -680 146.6496 107.2 2001 925.8476 -674 251.8476 107 2002 1036.9493 -644 392.9493 107.1 2003 1161.383 2 -616 545.3832 108 2004 1300.7491 -591 709.7491 105.6 2005 1456.8390 -569 887.8390 108.3 2006 1631.6597 -549 1082.6597 108.1 2007 1827.4589 -531 1296.4589 106.7 2008 2046.754 0 -515 1531.754 0 108.4 CACG 12.0% -1% 23%
-100
-82
-89
-126
-175
-229
-285
-349
-417
-491
-574
19%
458 -978 -419
607 -1040 -384.233 9.0% 341.4493 91
680 -750 12.19776 108.1% 9.632598 22
674 -587 213.25090 88 -1848.3% 149.65317 5
644 -517 344.93201 79 61.7% 215.10981 8
616 -261 671.6990 6 94.7% 372.2486 62
591 -261 754.37694 72 12.3% 371.51683 24
569 -261 847.19038 09 12.3% 370.76846 08
549 -261 953.89382 66 12.6% 370.98255 4
531 -261 1075.3532 86 12.7%
515 -261 1211.700 08 12.7% 372.1447 94
-1% 12%
-419
371.65185
26607.8016
8
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, PMV Other Assets, PMV Discounted Cash Flow Value
Value 1823.994 156 8171.951 96 -3800 23 12292 400 18910.94 612
% DCF 9.65% 43.21% -20.09% 0.12% 65.00% 2.12% 100.00%
Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) Discount to DCF Value Price Appreciation to DCF
565.2 $33.46 $37.50 -12.08% -10.78%
Terminal Multiple
13.00
WACC
12.53%
Year EBITDA Less: Depn and Amort EBIT
1998 659 -458 201
1999 751.26 -607 144.26
2000 856.4364 -680 176.4364
2001 976.3375 -674 302.3375
2002 1113.024 7 -644 469.0247
2003 1268.8482 -616 652.8482
2004 1446.487 0 -591 855.4870
2005 1648.995 1 -569 1079.995
2006 1879.854 5 -549 1330.854
2007 2143.0341 -531 1612.0341
2008 2443.058 8 -515 1928.058
CACG 14.0% -1% 25%
9
1 amortization Less: Taxes(EBIT+Amorti zation at 35%) Plus: Depreciation and Amortization Less: Capex FCF growth PV of FCF @ WACC 12.53% Terminal Value of 2008E Total EBITDA 84.7 104.1 107.2 107 107.1 108 105.6 108.3
5 108.1 106.7
8 108.4
-100 458 -978 -419
-87 607 -1040 -375.666 11.5% 333.8363 10
-99 680 -750 7.16366 111.3% 5.657158 25
-143 674 -587 246.0693 72 3335.0% 172.6842 01
-202 644 -517 394.3810 85 60.3% 245.9477 20
-266 616 -261 741.55133 6 88.0% 410.96007 1
-336 591 -261 849.1065 24 14.5% 418.1694 1
-416 569 -261 972.0918 37 14.5% 425.4309 33
-504 549 -261 1115.220 39 14.7% 433.7246 97
-602 531 -261 1280.4771 5 14.8% 442.54451 5
-713 515 -261 1469.298 2 14.7% 451.2599 31
22% -1% 12%
-419
31759.765
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, PMV Other Assets, PMV Discounted Cash Flow Value
Value 2253.542 33 9754.254 7 -3800 23 12292 400 20922.79 703
% DCF 10.77% 46.62% -18.16% 0.11% 58.75% 1.91% 100.00%
Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) Discount to DCF Value Price Appreciation to DCF
565.2 $37.02 $37.50 -1.30% -1.28%
10
Terminal Multiple
13.00
WACC
12.53%
11
A7. Horizon Value Formula: With our calculated WACC of 12.53% : TV = FCF(1+g)/(WACC – g) $38,454 = 1804(1 +g)/(12.53% - g) With Laura Martin’s WACC of 9.3% TV = FCF(1+g)/(WACC – g) $38,454 = 1804(1 +g)/(9.3% - g) g = 4.4% g = 7.49%
A8.
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). In addition, the option has an estimated 10 year life, which adds value as the holder of the option has a longer time to decide action. Finally for this scenario, the riskier the underlying, the more valuable the option. Volatility of 50% is high, adding value to the option. A9. Cash flows for the next 10 years generated under the stealth tier can be projected under different market condition scenarios. The cash flows under each scenario can then be discounted back to the current time, and the weighted average calculated to arrive at expected NPV of the tier” the
“stealth
9
102MHz/750MHz = 13.6% unused 750MHz cable plants Only 66% of plant will be upgraded to 750MHz. So, value of the 17 channel “stealth tier” is 0.136 x 0.66 = 0.08976
With 15 channels: With 10 channels:
0.08976/17 x 15 = 7.92% 0.08976/17 x 10 = 5.28%
With 5 channels: 0.08976/17 x 5 = 2.64%
A10. Based on the calculations the driver of enterprise value is the return on invested capital (ROIC). ROIC would increase should the real option be exercised, as EBITDA increases therefore increasing the return that is used when calculating ROIC. A11. This means that for the company, the stealth tier has a potential value (i.e. 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). A12. Black-Scholes Model Inputs Risk-free rate Time until option expires Strike price Current price of stock Variance Real Option 5.25% 10 years $1.22 $23.15 50%
It is estimated that the current value per channel for the stealth tier is $23.15. This 10
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. The strike price is the cost for Cox Communications to acquire the asset worth $23.15, i.e. to light up one channel. In this case, there is no actual cost to be incurred as the capacity is already there, so opportunity cost of foregone profit is used- i.e. if the channels are lit, there is an opportunity cost profit of $1.22 per channel, per home passed. Entering the relevant figures into the BS model: d1 = {ln(23.15/1.22) + [0.0525 + (0.5^2)/2]10} / (0.5√10) = 2.984 d2 = d1 – 0.5√10 = 1.403 N(d1)= N(2.984) = N(2.98) +0.4( N(2.99)-N(2.98)) =0.9986 +0.4 (0.9986-0.9986) =0.9986 N(d2)=N(1.403) = N(1.4) +0.3 (N(1.41)-N(1.40)) =0.9192 +0.3 (0.9207-0.9192) =0.91965 C = 23.15 (0.9986) - 1.22*0.91965*e^(-0.0539*10) = 22.46
BIBLIOGRAPHY 1. Brigham, E. and Daves, P. (2010) Intermediate Financial Management, SouthWestern Cengage Learning. 2. Damodaran, A. (2002) Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, John Wiley & Sons, Inc. 11
3. Saunders, A. et al (2007) Financial Institutions Management, McGraw-Hill.
12
Case Study Written Report
Week 8 Valuation: Laura Martin
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. …show more content…
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 2
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. How accurate the valuation is 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 Rsquared 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 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 a misleading outcome. R-squared is 70%. The percentage variation in ROIC cannot be totally explained by the variation in Adj. EV/Ave. Invested Capital. However, it does tell us that ROICs are a substantive prediction of value. The linear relationship between ROIC and the multiple in the regression shows there is a strong relationship. Martin’s DCF analysis Martin’s weighted cost of equity is 10.5%. 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. Using the synthetic rating method, after-tax cost of debt is 4.51% 3
(see A3), which is close to Martin’s estimate. Thus, with a WACC of 12.53% the stock price becomes a more conservative $41.70 (see A4). Martin’s projected EBITDA growth of 16% seems high since her forecasted revenue growth is only 14.2%. Hence, once other expenses are included, 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 $37.02 and $33.46 respectively (see A6). Martin assumes an increase in capital spending in the first 2 years on new digital technology services, and then a fall to a constant rate, resulting in a fall in asset intensity from 2003. But there is still 0.8% increase in ROIC as well as a forecasted growth in EBITDA of 16% and EBIT of 33%. These forecasts seem contradictory. Also, Martin has not taken into account the value of the empty cable channels. Substituting the terminal value into the horizon value formula using a WACC of 9.3% and 12.53% results in a growth rate of 4.4% and 7.49% respectively (see A7). Both stable growth rates seem reasonable, as FCF has been growing at a high rate (up to 474% in 2001). So we can conclude that the terminal value of 13x is reasonable, but it also depends on the reliability of the EBITDA forecast. Real options valuation as an alternative to DCF analysis Of the 750 MHz capacity in an upgraded cable plant, there are 17 unused channels (102 MHz), referred to as the “stealth tier”. DCF analysis does not account for these invisible but valuable revenue streams. The real option within this project is the “stealth tier”. It gives the company the right, but not the obligation, to obtain revenues from the unused cable channels, depending on market conditions. It allows the firm to calculate the intrinsic value of the underlying real project, unaccounted for in DCF analysis. Real options analysis will also allow managers to adjust business strategies according to market situations. Ways the “stealth tier” can be incorporated into DCF and multiples analysis 4
A qualitative assessment of the real option, which can be added to DCF analysis, shows that the value of the stealth tier would increase the value per share that is produced by DCF analysis (see A8).
The “stealth tier” could also be valued using decision-tree analysis (see A9). An investment timing option could also be incorporated, 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. Including the stealth tier option would impact the multiple analyses based on invested capital (see A10) and also EBITDA. For an effective valuation however, Cox Communications would have to be compared to companies that have a similar stealth tier, which is unrealistic. 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. 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), and it is up to management as to it being exercised or not. Martin used the Black-Scholes model to value this stealth tier. Inputs from the real option illustration can be obtained as required by the Black-Scholes model (see A12). Thus it appears that the B-S model can value the stealth tier due to it resemblance to a call option, and that the 14% premium on …show more content…
net value of the stealth tier per home passed of $341.65 is reliable. Some issues retracting from the reliability of such analysis include the degree of judgement involved in the input estimates, especially in estimates of variance. Also, since B-S model assumes that options are exercised only at maturity, there may be 5
extra value from exercising the stealth tier before maturity. Conclusion Looking purely at Martin’s analyses, all her valuation methods show that Cox Communications is currently underpriced. Despite high estimated implied values, multiples, regression and DCF analysis don’t take into account the value of the stealth tier. The BS model using real option equivalent inputs results in a value of the stealth tier of $381.65 per home passed which is at a 14% premium. It is advisable that investors purchase Cox. Most analyses reveal that the stock is undervalued. There is growth potential for the firm, with new developments in digital technology services and use of spare capacity channels. APPENDIX A1. Martin assumed a 0.8% increase in ROIC. This, combined into the regression analysis, resulted in an estimate of the Adj. EV/Avg. IC target multiple of 1.594. Applying this target multiple to fundamentals, and after adjustments were made, Martin arrived at an implied value of $50 for Cox’s share, higher than the current price of $37.50. [ A2. Cost of equity Martin’s rate is calculated based on 10-year risk-free rate, which is reasonable to reduce the uncertainty in forecasting 10 year EBITDA and free cash flows, though a 10-year zero-bond would be preferable. A levered beta of 1.54 rather than an equity beta of 1.07 should be used to reflect the financial risk arising from debt. However, the levered beta is sensitive and fluctuates, making it hard to predict the future beta. bL = bU (1 + (1 – T)D/E) = 1.07 [1 + (1 – 0.39)(3885.3/5376.6)] = 1.54
6
Also, a risk premium of 5.51%, calculated over a longer historical period should be used to reduce standard error. Stocks bills AR 19282000 19622000 19902000 8.41% 6.41% 11.42% versus GR 7.17% 5.25% 7.64% treasury Stocks versus Treasury Bonds AR 6.53% 5.30% 12.67% GR 5.51% 4.52% 7.09%
The adjusted cost of equity then becomes 13.61%. Cost of equity= rf+ RP* βL = 5.51% x 1.54 + 5.12% = 13.61%
A3. 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, with an after-tax cost of debt of 4.51%, which is close to Martin’s estimate. Interest coverage ratio = operating income/ interest expense = 659.1/223.3 = 2.95 7
Hence the Cox Communication is within BBB rating with spread 2.25% After-tax cost of debt = (2.25% + 5.12%) x (1-0.39) =4.51% Using a credit scoring model, the Altman Z Score Model, we evaluate the riskiness of Cox Communications. Z=1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 X1 = Working capital/total assets = ? X2 = Retained earnings/total assets = 2944.5 / 12878.1 = 0.2286 X3 = EBIT/total assets = 201/12878.1 = 0.016 X4 = Market value equity/book value LT debt = 21195/3885.3= 7.15 X5 = Sales/total assets =1716.8/12878.1=0.133 Z= 1.2x___ + 1.4x0.2286 + 3.3 x 0.016 + 0.6 x 7.15 + 1 x 0.133 >4.796 Critical values of Z < 1.81 and Z > 2.99. Therefore, even with an unknown X1, the Z-score is greater than 2.99. This indicates that Cox Communications is pretty safe.
A4. WACC = [13.61% x 28260/(28260+3800)] + [4.50% x 3800/(28260+3800)] = 12.53% Thus, with a WACC of 12.53% the stock price becomes a more conservative $41.70.
8
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 12.53% Terminal Value of 2008E Total EBITDA Equity Valuation Analysis
199 8 659 -458 201 84.7
1999 800 -607 193 104.1
2000 924 -680 244 107.2
2001 1047 -674 373 107
2002 1214 -644 570 107.1
2003 1408 -616 792 108
2004 1634 -591 1043 105.6
2005 1895 -569 1326 108.3
2006 2198 -549 1649 108.1
2007 2550 -531 2019 106.7
2008 2958 -515 2443 108.4
CACG 16.2% -1% 28%
-100
-104
-123
-168
-237
-315
-402
-502
-615
-744
-893
24%
458 -978 -419
607 -1040 -343.985 21.8% 305.6829 29
680 -750 51.08 114.8% 40.337989 71
674 -587 292 471.7% 204.91695 55
644 -517 460.015 57.5% 286.87897 32
616 -261 832 80.9% 461.08578 35
591 -261 970.99 16.7% 478.19479 43
569 -261 1131.99 5 16.6% 495.411 72
549 -261 1322.015 16.8% 514.14999 02
531 -261 1545.005 16.9% 533.96773 97
515 -261 1804.01 16.8% 554.05866 58
-1% 12%
-419
3845 4 Value 2844.319 683 11810.22 94 % DCF 12.07% 50.11% Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) 565.2 $41.70 $37.50
PV of Unlevered FCF PV of TV discounted to 1999
6
(Long term Debt at 12/21/99E) Cash at 12/31/99E Non-Consolidated Assets, PMV Other Assets, PMV Discounted Cash Flow Value
-3800 23 12292 400 23569.54 908
-16.12% 0.10% 52.15% 1.70% 100.00%
Discount to DCF Value Price Appreciation to DCF
10.07% 11.20%
Terminal Multiple
13.00
WACC
12.53%
7
A6.
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 12.53% Terminal Value of 2008E Total 1998 659 -458 201 84.7 1999 738.08 -607 131.08 104.1 2000 826.6496 -680 146.6496 107.2 2001 925.8476 -674 251.8476 107 2002 1036.9493 -644 392.9493 107.1 2003 1161.383 2 -616 545.3832 108 2004 1300.7491 -591 709.7491 105.6 2005 1456.8390 -569 887.8390 108.3 2006 1631.6597 -549 1082.6597 108.1 2007 1827.4589 -531 1296.4589 106.7 2008 2046.754 0 -515 1531.754 0 108.4 CACG 12.0% -1% 23%
-100
-82
-89
-126
-175
-229
-285
-349
-417
-491
-574
19%
458 -978 -419
607 -1040 -384.233 9.0% 341.4493 91
680 -750 12.19776 108.1% 9.632598 22
674 -587 213.25090 88 -1848.3% 149.65317 5
644 -517 344.93201 79 61.7% 215.10981 8
616 -261 671.6990 6 94.7% 372.2486 62
591 -261 754.37694 72 12.3% 371.51683 24
569 -261 847.19038 09 12.3% 370.76846 08
549 -261 953.89382 66 12.6% 370.98255 4
531 -261 1075.3532 86 12.7%
515 -261 1211.700 08 12.7% 372.1447 94
-1% 12%
-419
371.65185
26607.8016
8
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, PMV Other Assets, PMV Discounted Cash Flow Value
Value 1823.994 156 8171.951 96 -3800 23 12292 400 18910.94 612
% DCF 9.65% 43.21% -20.09% 0.12% 65.00% 2.12% 100.00%
Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) Discount to DCF Value Price Appreciation to DCF
565.2 $33.46 $37.50 -12.08% -10.78%
Terminal Multiple
13.00
WACC
12.53%
Year EBITDA Less: Depn and Amort EBIT
1998 659 -458 201
1999 751.26 -607 144.26
2000 856.4364 -680 176.4364
2001 976.3375 -674 302.3375
2002 1113.024 7 -644 469.0247
2003 1268.8482 -616 652.8482
2004 1446.487 0 -591 855.4870
2005 1648.995 1 -569 1079.995
2006 1879.854 5 -549 1330.854
2007 2143.0341 -531 1612.0341
2008 2443.058 8 -515 1928.058
CACG 14.0% -1% 25%
9
1 amortization Less: Taxes(EBIT+Amorti zation at 35%) Plus: Depreciation and Amortization Less: Capex FCF growth PV of FCF @ WACC 12.53% Terminal Value of 2008E Total EBITDA 84.7 104.1 107.2 107 107.1 108 105.6 108.3
5 108.1 106.7
8 108.4
-100 458 -978 -419
-87 607 -1040 -375.666 11.5% 333.8363 10
-99 680 -750 7.16366 111.3% 5.657158 25
-143 674 -587 246.0693 72 3335.0% 172.6842 01
-202 644 -517 394.3810 85 60.3% 245.9477 20
-266 616 -261 741.55133 6 88.0% 410.96007 1
-336 591 -261 849.1065 24 14.5% 418.1694 1
-416 569 -261 972.0918 37 14.5% 425.4309 33
-504 549 -261 1115.220 39 14.7% 433.7246 97
-602 531 -261 1280.4771 5 14.8% 442.54451 5
-713 515 -261 1469.298 2 14.7% 451.2599 31
22% -1% 12%
-419
31759.765
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, PMV Other Assets, PMV Discounted Cash Flow Value
Value 2253.542 33 9754.254 7 -3800 23 12292 400 20922.79 703
% DCF 10.77% 46.62% -18.16% 0.11% 58.75% 1.91% 100.00%
Shares Outstanding @ 9/30/99 Discounted Cash Flow Value/Share Current Share Price (4/26/99) Discount to DCF Value Price Appreciation to DCF
565.2 $37.02 $37.50 -1.30% -1.28%
10
Terminal Multiple
13.00
WACC
12.53%
11
A7. Horizon Value Formula: With our calculated WACC of 12.53% : TV = FCF(1+g)/(WACC – g) $38,454 = 1804(1 +g)/(12.53% - g) With Laura Martin’s WACC of 9.3% TV = FCF(1+g)/(WACC – g) $38,454 = 1804(1 +g)/(9.3% - g) g = 4.4% g = 7.49%
A8.
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). In addition, the option has an estimated 10 year life, which adds value as the holder of the option has a longer time to decide action. Finally for this scenario, the riskier the underlying, the more valuable the option. Volatility of 50% is high, adding value to the option. A9. Cash flows for the next 10 years generated under the stealth tier can be projected under different market condition scenarios. The cash flows under each scenario can then be discounted back to the current time, and the weighted average calculated to arrive at expected NPV of the tier” the
“stealth
9
102MHz/750MHz = 13.6% unused 750MHz cable plants Only 66% of plant will be upgraded to 750MHz. So, value of the 17 channel “stealth tier” is 0.136 x 0.66 = 0.08976
With 15 channels: With 10 channels:
0.08976/17 x 15 = 7.92% 0.08976/17 x 10 = 5.28%
With 5 channels: 0.08976/17 x 5 = 2.64%
A10. Based on the calculations the driver of enterprise value is the return on invested capital (ROIC). ROIC would increase should the real option be exercised, as EBITDA increases therefore increasing the return that is used when calculating ROIC. A11. This means that for the company, the stealth tier has a potential value (i.e. 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). A12. Black-Scholes Model Inputs Risk-free rate Time until option expires Strike price Current price of stock Variance Real Option 5.25% 10 years $1.22 $23.15 50%
It is estimated that the current value per channel for the stealth tier is $23.15. This 10
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. The strike price is the cost for Cox Communications to acquire the asset worth $23.15, i.e. to light up one channel. In this case, there is no actual cost to be incurred as the capacity is already there, so opportunity cost of foregone profit is used- i.e. if the channels are lit, there is an opportunity cost profit of $1.22 per channel, per home passed. Entering the relevant figures into the BS model: d1 = {ln(23.15/1.22) + [0.0525 + (0.5^2)/2]10} / (0.5√10) = 2.984 d2 = d1 – 0.5√10 = 1.403 N(d1)= N(2.984) = N(2.98) +0.4( N(2.99)-N(2.98)) =0.9986 +0.4 (0.9986-0.9986) =0.9986 N(d2)=N(1.403) = N(1.4) +0.3 (N(1.41)-N(1.40)) =0.9192 +0.3 (0.9207-0.9192) =0.91965 C = 23.15 (0.9986) - 1.22*0.91965*e^(-0.0539*10) = 22.46
BIBLIOGRAPHY 1. Brigham, E. and Daves, P. (2010) Intermediate Financial Management, SouthWestern Cengage Learning. 2. Damodaran, A. (2002) Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, John Wiley & Sons, Inc. 11
3. Saunders, A. et al (2007) Financial Institutions Management, McGraw-Hill.
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