Multiples analysis is easy to comprehend and implement but can be influenced by accounting manipulation. Acquiring a truly comparable large sample of firms is challenging. Multiples analysis looks at historical/current data to determine multiples, focusing on relative value instead of the intrinsic value provided by DCF valuation. DCF analysis calculates intrinsic value by using firm-specific data and includes the time value of money, making it a forward-looking measure.
However, predicting future revenues is uncertain, particularly for private firms and those with minimal or no cash flows. Multiples analysis assumes that other firms in the industry are comparable to the firm being valued. It is believed that the market generally prices these firms correctly, but may make errors when pricing individual stocks. Exhibit 2 displays a selection of comparable firms, assuming they have the same growth, risk, and return as Cox Communications.
There is a belief that financial fundamentals, like EBITDA, have the same definition and accounting methods across all companies. Exhibit 5 assumes that there is a positive linear relationship between ROIC and the multiple Adjusted Enterprise Value/Average Invested Capital. Regression analysis and traditional multiples analysis are similar in that they both predict the underlying value of the firm and are based on historical data. The future value of the firm is determined using past inputs.
Both traditional multiples analysis and regression analysis assume that firms in the same industry are comparable. However, they differ in their approaches. Traditional multiples analysis is more arithmetic and involves finding the average multiple among comparable firms, which is then applied to the firm’s fundamentals. The accuracy of the valuation depends on how comparable the firms in the industry are. On the other hand, regression analysis produces a statistical regression line that relates each comparable firm’s multiple to the fundamentals that affect the value of the multiple. The R-squared of the regression provides a measure of how effectively that multiple works within the sector.
After running the regression and establishing the multiple, the multiple is applied to fundamentals in order to determine the firm’s valuation price. When interpreting Martin’s regression results, it shows that the share price is estimated to be $50 (see A1), suggesting that the shares are currently undervalued and Cox Communications has potential for growth. However, Martin’s heavy reliance on the projection of the ROIC value is concerning, as the 0.8% projection appears to be arbitrary and any inaccuracies in this projection may lead to misleading conclusions.
R-squared is 70%. The variation in ROIC is not completely explained by the variation in Adj. EV/Ave. Invested Capital, but it indicates that ROICs are a meaningful predictor of value. The regression analysis shows a strong linear relationship between ROIC and the multiple. Martin’s DCF analysis reveals that Martin’s weighted cost of equity is 10.5%. We have determined the cost of equity to be 13.61% (see A2), which is calculated using a levered beta and a risk premium based on a longer historical period.
Using the synthetic rating method, the after-tax cost of debt is 4.51% (see A3), which closely aligns with Martin’s estimate. As a result, with a WACC of 12.53%, the stock price is more conservative at $41.70 (see A4). Martin’s projected EBITDA growth of 16% seems optimistic considering her forecasted revenue growth of only 14.2%. Therefore, it is unlikely that EBITDA will maintain higher growth compared to revenue once other expenses are factored in. Conducting sensitivity analysis with more cautious EBITDA growth rates of 14% and 12%, yields resulting share prices of $37.02 and $33.6 respectively (see A6). Martin assumes there will be an initial increase in capital spending for the first two years on new digital technology services, followed by a decline to a constant rate, leading to decreased asset intensity from 2003.
Despite a contradictory forecast showing a 0.8% increase in ROIC and projected growth rates of 16% for EBITDA and 33% for EBIT, the value of the unused cable channels has not been taken into consideration by Martin. By substituting the terminal value into the horizon value formula using a WACC of 9.3% and 12.53%, growth rates of 4.4% and 7.9% are obtained respectively (see A7). These stable growth rates seem reasonable, especially considering that FCF has been growing at a high rate (up to 474% in 2001). Thus, it can be concluded that the terminal value of 13x is reasonable, although its reliability also depends on the EBITDA forecast. An alternative option worth considering is real options valuation instead of DCF analysis. The upgraded cable plant contains an additional revenue stream from the “stealth tier” which consists of 17 unused channels (102 MHz) that are not accounted for in DCF analysis. These valuable but invisible revenue streams present a real option within this project.
The company has the option, but not the obligation, to generate revenues from unused cable channels based on market conditions. This option allows the company to determine the true value of the underlying real project, which is not accounted for in DCF analysis. Real options analysis also enables managers to adjust business strategies based on market conditions. Incorporating the “stealth tier” into DCF and multiples analysis can be achieved through a qualitative assessment of the real option. This assessment reveals that including the value of the stealth tier in DCF analysis increases the value per share (see A8).
The use of decision-tree analysis (refer to A9) could determine the value of the “stealth tier.” Additionally, Cox Communication could consider incorporating an investment timing option to assess the profitability of utilizing the empty channels immediately or delaying it until a later date. By including the stealth tier option, multiple analyses revolving around invested capital (as mentioned in A10) and EBITDA would be affected.
For an effective valuation, CoxCommunications would need to be compared to companies with a similar stealth tier, which is unrealistic. The stealth tier is comparable to a call option because the company has the right but not the obligation to use the unused capacity for more operating capacity. Therefore, deciding whether to use this capacity is a real option as the stealth tier holds value and incurs a cost. (see A11).
