How Courts View Valuation Methods In Appraisal Litigation

Law360, New York (May 20, 2016, 12:10 PM ET) -- The debate over appropriate financial projections in the ongoing Dell appraisal rights litigation highlights an increasingly important issue: whether a judge will accept an expert’s valuation analysis depends critically on the details of how that analysis was performed.[1] In the Dell matter, counsel for the investors attacked one of the company’s expert witnesses for inappropriately adjusting projection figures and relying upon “litigation-driven forecasts.”[2]

This debate is the most recent chapter in a wave of M&A-related appraisal claims cases where certain shareholders abstain from a merger offer and opt instead to let a court determine the “fair value” of their shares. These claims have become more frequent in the Delaware Court of Chancery as hedge funds and other asset managers have developed investment strategies based on appraisal.[3] With valuation typically at the heart of these cases, it has become increasingly important for experts and counsel to stay current on the key issues surrounding valuation methodologies and how the courts view these strategies.

To gain insight into courts’ preferences regarding valuation techniques, we reviewed 15 publicly available opinions issued by the Delaware Chancery Court in M&A appraisal rights litigation cases since the beginning of 2013. Based on this review, we have reached the following conclusions:

1. Judges still consider the discounted cash flow (DCF) approach, when used appropriately, as the standard method for valuing firms.

2. Judges consider a multiples approach using comparable companies or transactions as a valid valuation technique, but often discard it when the court does not find the comparables to be adequately similar.

3. Judges’ decisions to accept an expert’s work depend crucially on the details. The three main reasons judges rejected or modified an expert’s work were:

a. The expert chose an unrealistic long-term growth rate.

b. The expert relied on overly optimistic projections by management.

c. The expert valued the company based on “comparables” that were not adequately similar.

Valuation Approach: Discounted Cash Flow (DCF)

Courts have long considered the DCF approach as a standard method for valuing firms.[4] DCF models involve two steps: 1) predicting firms’ future cash flows and expected long-term growth rate; and 2) computing appropriate rates at which to discount these cash flows, accounting for their riskiness (i.e., riskier cash flows are assigned lower values). The net present value of these expected future cash flows to shareholders can be used to estimate the fair value of a firm.

The Delaware Chancery Court views DCF models, when used appropriately, as the preferred way to value a firm.[5] In fact, experts used DCF models in 14 of the 15 cases we analyzed.[6] In 10 cases, the judges relied upon a DCF model in forming their opinions.

Valuation Approach: Multiples Analysis

Another common approach experts use to value a company is based on a multiple determined by looking at comparable companies or transactions. Multiples are typically expressed as a market value relative to an accounting-based measure that reflects the assets and/or operations of the business.

Although not quite as common as DCF models, multiples-based valuation approaches were used by experts in nine of the 15 cases we reviewed. While valuations can appear more credible when they combine DCF and multiples approaches to “cross-check one another’s results,”[7] it is striking that in the nine instances where multiples-based analyses were presented, the judge rejected them in all but one case.

Methodological Details are Critical

The details of how an expert implements these valuation methodologies ultimately determine whether the judge views them as reliable. In our sample, the judges often expressed concerns about specific inputs to DCF models, but rather than discard experts’ models entirely, the judges often updated them with their own choice of inputs.

The judges were even more critical of multiples-based approaches. They expressed concerns over experts’ methodologies in eight of the nine cases where multiples-based valuations were presented. The remainder of this article provides an overview of the three most common methodological issues that judges raised in the cases in our sample.

Management Projections

Forecasts of the firm’s future cash flows are a key input into any DCF model. Since a firm’s management team is the most intimately familiar with the business, it is common for expert witnesses to rely on management’s projections of future cash flows made prior to the initiation of the relevant litigation. In all of the cases we reviewed, the experts who presented DCF models relied on internal management projections to estimate future cash flows.[8]

In our sample, judges sometimes criticized management projections for three reasons:

1. They were not prepared in the ordinary course of business.

2. Management did not have a history of preparing them.

3. The firm consistently underperformed its projections in the past.[9][10]

In five of the 14 cases we reviewed where experts relied on management’s projections, judges criticized these projections as having been specifically prepared for a merger consideration. Judges did not consider these forecasts to be reliable since they were not prepared in the ordinary course of business, and therefore management could have had an incentive to overstate future performance in order to make the firm appear more attractive as an acquisition target.

Although experts typically relied on management projections, in one case, the judge accepted revised projections because the expert was able to demonstrate that the initial projections did not represent the expected future performance of the company. Specifically, in the litigation concerning Nine Systems Corp.’s recapitalization, the judge permitted the downward revision of revenue projections after the defendant’s expert successfully demonstrated that the firm’s realized cash flows consistently fell well below its projected cash flows. In his ruling, the judge stated that management had “grossly overestimated the Company’s revenues, even two to three months away,” and that the further away the projection, “the greater the overestimation.”[11]

Terminal Growth Rate

Although management often projects its firm’s cash flows out a number of years to provide guidance about future performance, a DCF requires forecasting cash flows into perpetuity. In most DCF models, the expert must make an assumption about the expected cash flows after the management projections end. The two most common approaches are either to assume a terminal growth rate — a constant rate at which the firm is assumed to grow in perpetuity — or to apply a terminal multiple to the latest year’s cash flow.

In all but one of the cases we reviewed where experts presented DCF models, they used a terminal growth rate instead of a terminal multiple. The terminal growth rates ranged from 0 percent to 5 percent in perpetuity.

Based on our review, we found that judges argued that an appropriate terminal growth rate for a profitable company with little risk of insolvency should generally have a lower bound of the expected rate of inflation and an upper bound of the expected nominal growth rate of the economy. On the one hand, if a company were to grow slower than the rate of inflation in perpetuity, the purchasing power of its cash flows would approach zero. On the other hand, if a company were expected to grow faster than nominal GDP in perpetuity, “its cash flow would eventually exceed America’s [gross national product].”[12]

Multiples Approaches

The challenge in using comparable companies or transactions to value a firm is finding a sufficient number of companies and transactions that are similar enough to the firm being valued.

Judges expressed skepticism about multiples-based valuations for three main reasons:

1. Inadequately similar comparable companies.

2. Insufficient number of adequately similar comparable companies.

3. Large dispersion in multiples across the comparable companies.

For example, in Merion Capital LP v. 3M Cogent Inc., the judge ruled that the companies used in the multiples approach were too dissimilar to provide a reliable valuation, citing in particular that the comparable companies that the expert used were “significantly different in size than the appraised company.” In the same opinion, the judge also argued that the “dearth of data points” available undermined the reliability of the analysis.[13]

In LongPath Capital LLC v. Ramtron International Corp., the judge cited concerns regarding the range of multiples the experts’ methodologies produced based on the comparable companies chosen. He argued that if “the dispersion of the multiples” is too large to be reliable, then the multiples can be found to violate the “law of one price” and should not be used in determining a fair value.[14]

Conclusion

While there are commonly accepted valuation frameworks, whether a judge will view an expert’s valuation as reliable depends critically on the details of the methodology. We have reviewed the recent opinions on appraisal rights cases in the Delaware Court of Chancery and summarized the common critiques judges have made of various experts’ work. However, with the large number of ongoing appraisal rights cases, we expect the key issues to continue to evolve at a rapid pace, and it will be important to closely monitor these developments.

—By David F. Marcus, Frank Schneider and Joseph B. Doyle, Cornerstone Research

David F. Marcus is a senior vice president, Frank Schneider is a principal and Joseph Doyle is a manager in the Boston office of Cornerstone Research.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] In re Appraisal of Dell Inc., Case No. 9322 (Del. Ch.).

[2] Chiappardi, M., “Investors Attack Key Expert in Dell Stock Appraisal Fight,” Law360, March 2, 2016.

[3] Korsmo, C. and M. Myers, “Appraisal Arbitrage and the Future of Public Company M&A,” Washington University Law Review, 92(6), 2015, pp. 1551–1615.

[4] Andaloro v. PFPC Worldwide Inc., 2005 WL 2045640 (Del. Ch. Aug. 19, 2005).

[5] Andaloro v. PFPC Worldwide Inc., 2005 WL 2045640 (Del. Ch. Aug. 19, 2005).

[6] The exception was Laidler v. Hesco Bastion Environmental Inc. The experts agreed that a DCF was not feasible as “Hesco’s management never made cash flow projections in the ordinary course of its business.” Instead, the experts each conducted a direct capitalization of cash flows analysis. Laidler v. Hesco Bastion Envtl. Inc., 2014 WL 1877536 (Del. Ch. May 12, 2014).

[7] In re Hanover Direct Inc. S’holders Litig., 2010 WL 3959399 (Del. Ch. Sept. 24, 2010); S. Muoio & Co. LLC v. Hallmark Entm’t Invs. Co., 2011 WL 863007 (Del. Ch. Mar. 9, 2011).

[8] In Towerview LLC v. Cox Radio Inc., the respondent’s expert performed an additional DCF analysis based on consensus analyst EBITDA (earnings before interest, taxes, depreciation, and amortization) estimates. Towerview LLC v. Cox Radio Inc., 2013 WL 3316186 (Del. Ch. June 28, 2013).

[9] Huff Fund Inv. P’ship v. CKx Inc., 2013 WL 5878807 (Del. Ch. Nov. 1, 2013).

[10] Merlin Partners v. AutoInfo Inc., 2015 WL 2069417 (Del. Ch. Apr. 30, 2015).

[11] In Re Nine Sys. Corp., 2014 WL 4383127 (Del. Ch. Sept. 14, 2014).

[12] Owen v. Cannon, 2015 C.A. No. 8860-CB (Del. Ch. June 17, 2015) (brackets in original).

[13] Merion Capital LP v. 3M Cogent Inc., 2013 WL 3793896 (Del. Ch. July 8, 2013).

[14] LongPath Capital LLC v. Ramtron Int’l Corp., 2015 C.A. No. 8094-VCP (Del. Ch. June 30, 2015).

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