Should You Buy These 2 Media Stocks?

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you are looking to invest in media now, there are several variables you should consider. First, I recommend carefully observing contracts, as they are evidence of future streams of free cash flow and corporate positions in secular transactions. Second, I encourage a review of the growth prospects relative to valuation. Weighing these two considerations, I provide my outlook on several media businesses below.

Pros & Cons of a Time Warner (NYSE: TWX) Investment

This diversified entertainment company has been on a roll. It is up 43.8% from its 52-week low and right around its 52-week high. At 12.9x forward earnings and a 5-year EPS growth rate forecast of 11.9%, risk/reward is fairly compelling. 18 of 27 reporting analysts are calling it a "buy" or better, but 9 are still on the fence with a "hold." Overall, the $50.12 price target on the Street is nominally higher than the prevailing price.

There are several reasons why Time Warner is a mixed bag. First, it's return on invested capital is terrible at 7.5%--below what is necessary to drive value creation and 450 bps lower than the industry average. Put differently, Time Warner can continue to grow at these impressive rates; but, if it isn't creating value in the process then the growth is a disservice for short-term investors.

On the other hand, I like the company's strategic decisions. Hiring Jeff Zucker, an experienced executive with a proven track record, at CNN was a step in the right direction. CNN has been profitable, but it's revenue growth has fallen behind competing networks. Then, in the studio business, it is moving fast. Time Warner recently secured $1.125 billion in debt for new film movies, which effectively enables Warner Bros to produce movies beyond October 2014 when it would have otherwise been financially constrained. And, as a short term catalyst, investors have the release of The Hobbit to look forward to, which has been cited by management as a major growth driver.

While the company is 21.2% undervalued relative to the Greenblatt fair value calculation, it is 32.4% overvalued relative to the Graham intrinsic value calculation. It's ROA of 3.9% is 207, 450, and 669 bps below CBS's, Disney's, and Viacom's, respectively. Coupled with nonexistent value creation and deceleration in media networks, this is reason enough to avoid the stock.

Why You Should Buy Viacom (NASDAQ: VIAB)

Viacom is a much more preferable investment. It trades at only 10x forward earnings and a PEG ratio of 0.85x. The media company generates a free cash flow yield of 9.1% and is forecasted for 14.6% annual EPS growth over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $8.18. At a multiple of 15x, this translates to a future stock value of $122.70. Discounting backwards by 10% yields a present value of $76.19. This is at around a 50% premium to the current market assessment and easily warrants a "buy."

Moreover, Viacom is expected to grow EPS at a rate that is 730 bps greater than the broadcasting & entertainment industry average. It has already been demonstrated that the company is also above peers in ROA. It should further be noted that the company has a 14.1% return on invested capital, which is more than 200 bps above the industry average. There is little reason why the company should be traded at this discount for these excellent fundamentals, especially when there are peers out there that trade at unreasonably high multiples.

AMC Networks (NASDAQ: AMCX), for example, trades at 25.5x past earnings, yet has seen flattish earnings trends. Caris & Company recently broke the ice in late November with the "below average" rating. While return on invested capital is excellent at 15.6%, leverage is very high with a net debt position of $1.9 billion, or half of the market capitalization. Even though the Street is still forecasting around 19.9% per annum growth over the next 5 years, I wouldn't go for the stock when Viacom is generating nearly just as good returns in return for a larger economic moat and excellent fundamentals.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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