Laura Martin: Real Options and the Cable Industry Harvard Case Solution & Analysis

Laura Martin: Real Options and the Cable Industry

Laura Martin was an equity research analyst for cable stocks, which accepted that the most ideal approach to value cable stocks was through innovative strategies, for example, real option and not through more customary or common valuation systems, for example, EBITDA multiples, Return on Invested Capital (ROIC) and Discounted Cash Flow (DCF) analysis. In the conference held by the Credit Suisse First Boston in 1999, Laura Martin presented the real option strategy for the valuation of cable stocks in-front of the CEO of Adelphia Communication, AT&T’s Cable Operations, and Cox Communication that also included the VC of Comcast Communications. She additionally needed to have the chance to exhibit her learning of the drivers of value in the cable business. The primary motivation behind Laura Martin’s argument about real option was the right technique for valuing cable stocks; which was primarily determined by the development that this industry was experimenting. In this time period, cable organizations were overhauling their cable infrastructure to meet the 750 MHz of bandwidth speed limit, which left unused data bandwidth limit that could be utilized for other interactive services or services that did not exist at that time. Laura Martin believed that the EBITDA as multiplier and the DCF valuation approaches did not evaluate this reasonable income stream; which she named “Stealth Tier”. Her analysis prompted a higher stock value by using the real option valuation approach and for the lower values by using afore mentioned traditional approaches.




Sell side of the equity is representing the brokerage firms because they provide the in depth analysis reports based on the equity and shares; which determines the enterprise value, net present value and per share price for mergers and acquisition purposes. They also sell these reports to buy side (assets management companies, investment banks, and money management firms) clients. It provides the accumulated unique, in depth quality analysis reports. Equity side is based on the relationship between the brokerage houses and firms.

Buy side of the equity is referred to assets management companies; these companies perform internal analysis of the firms with respect to the projection of the money market. These reports are distributed to firm’s internal analyst for the evaluation of the firm’s performances. These analysts incorporate the optimal position of stock to value the firm accurately with the maximization of the size and value of the portfolio.
Studies show a relationship in between value and return for invested capital. In this case, correlation between value and return is 80%. This infers that future ROIC's are predictive with respect to the value. ROIC is computed by division of net working profit after taxes through the average contributed capital for the period (it is also calculated by summing the fixed assets and net working capital). The correlation between the ROIC along with the valuation of cable and entertainment businesses is characterized using the ratio of enterprise value with average invested capital. By anticipating the ROIC for the year, the estimation incorporated for the target enterprise value to invested capital multiple is done by using the regression line. Through this, adjustment made after considering the other factors which lead towards the target price as $50 for Cox Stock. This intimates that there is upside potential with respect to the current price of $37.5 for Cox Stock or this stock is currently trading at lower prices with respect to the potential price of stock. In reality, if firms have incurred higher returns on its invested capital and have low value in result than it means that firms have potential to increase their value by eliminating the riskiness within the operations.

Another traditional approach is EBITDA multiple approach, which is used for the valuation of the cable industry. EBITDA multiple uses the historical data for future prediction, which is not an effective approach to determine the value of stock. On the other hand, using this approach means that the higher expected stock price is not an effective prediction.

With respect to the usage of the discounted cash flow valuation approach, a careful understanding of the business being broke down incorporated with the meaningful assumptions for the heads used in the analysis. For this reason, Laura accepted that this was still a decent valuation approach to seek the value of a stock for a particular industry. She emphasized the benefit of DCF, that DCF is a forward looking approach by incorporating the time value of money concept in it. It depends upon the specific financial data obtained from the financials of the firm to obtain the specific value of the firm. Terminal value as 13.3 EBITDA multiple is $439,280 which is shown in the Excel file. The implied growth rate for the further free cash flows calculation will be the 14.6%; which is calculated by using the given below ...............................

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CSFB equity analyst Laura Martin publishes a report on the evaluation of Cox communications, which introduces an innovative approach to the assessment. She argues that the EBITDA multiple analysis, typical for the cable industry, is invalid because it does not account for the value of "stealth-tier" (unused capacity on the cable companies fiber optic network). Martin offers a viable option to use the estimate to impute value for stealth level, and so she comes to a higher estimate for the stock Cox. This provides the context for contrasting multiple valuation techniques - traditional analysis of DCF, based on ROIC and multiple regression analysis and the theory of real options - and to assess whether the selected assumptions impact valuation techniques. In particular, Martin reviews how the industry is growing, and the students can think about how these changes affect the evaluation method which is most appropriate. In general, this case provides a context for discussion of the role of analysts Equity Research, highlighting all the districts they serve and how it can create a conflict of interest. The application of real options theory, Martin allows us to estimate where it works, where it does not, and why. "Hide
by Mihir A. Desai, Peter Tufano Source: Harvard Business School 15 pages. Publication Date: August 23, 2000. Prod. #: 201004-PDF-ENG

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