“In a competition of experts to see which can generate the greatest judicial skeptism regarding valuation, this case, so far, takes the prize.”
These were the words of the Vice Chancellor of the Court of Chancery of the State of Delaware in a recent judgement which should resonant with all valuers, whether they are providing evidence in court or not.
Analysing or estimating the benefits that will accrue to an owner of an asset are at the heart of most valuation methods for a good reason. Actual or imputed revenues provide an empirical basis for estimating the value of those benefits and can explain or justify that estimate. Two recent judicial decisions concerning very different assets situated in different jurisdictions illustrate that the courts prefer methods that provide the most detailed analysis of current or projected cash flow.
The Delaware case Re ISN Software Corp arose from a disagreement as to the fair value of two minority shareholders’ interests following a merger of the company. The experts for the two plaintiffs put forward similar valuations of (in round figures) $230,000 and $222,000 per share. The contrast between these valuations and that of $29,000 put forward by the expert for the respondent were the reason for the judge’s pithy observation at the top of this article. The experts used multiple methods to arrive at their opinions. All three had used a discounted cash flow (DCF) model and a guideline public company (GPC) method. Two also used the evidence of other transactions and one a direct capitalisation of cash flow (DCCF) method. However, each expert put a different weight on the results obtained from each method.
The Vice Chancellor ignored the experts’ weightings and relied solely on the DCF method, rejecting the other methods put forward. The reasons he gave were that, on the facts of this case:
The prior transactions of the company’s shares were not open market transactions and also included non-cash consideration.
The prior transactions in other companies’ shares were not considered to be sufficiently similar
The DCCF method because company cash flows had not stabilised so the current income could not reasonably be assumed to continue into the future.
The GPC method because the company had no publicly quoted competitors and it was difficult to in identify any quoted company with similar characteristics.
The judge adopted the DCF model of one of the experts and then adjusted the various inputs after considering the rationale provided by each expert as to whether an item should be included and, if so, what figure was the most appropriate. He concluded that fair value per share should be, in round terms, $99,000 and awarded accordingly.
At much the same time, on the other side of the Atlantic, the High Court of Justice in London also had to consider the most appropriate method in a valuation involving estimated cashflows. Barclays v Christie Owen & Davies concerned alleged negligence against a valuation firm by the claimant bank. The defendant valuers had valued adjoining seaside family amusement arcades in 2007 at a combined value of £4.2m. Following a default by the borrower in 2010, the arcades were sold for a significantly lower figure, resulting in a loss to the bank. The bank contended that the correct value at the time of the 2007 valuations was £3.1m. This was a case that really has something for everybody with the issues in contention including the experience and impartiality of one of the experts, the efficacy of conditions in the report, the way in which the loss was calculated and the extent to which the bank contributed to that loss. In this article I just summarise the valuation arguments.
There were opposing arguments as to whether the court should agree with one or other of the experts rather than attempt its own valuation or whether it should decide the weight to be placed on the different aspects of the experts’ evidence and then reach its own conclusion as to the true value. The Court agreed with the second argument and set about analysing the experts' evidence with enthusiasm.
In preparing the disputed valuation, the defendants had adopted a method of applying a multiplier to the turnover of each arcade. It was common ground between the expert valuers appointed for the trial that the preferred method would be to estimate earnings before interest, tax, depreciation and amortisation (EBITDA) and then apply an appropriate multiplier (capitalisation rate) to estimate the value. However, the expert for the defendant valuers defended the use of a multiplier of turnover on the grounds that there was little reliable evidence to support the analysis required to calculate EBITDA but that turnover information was more freely available for comparable businesses.
The court was not persuaded that there was any established authority for the use of a turnover multiplier, or that armed with knowledge of the turnover, a buyer in the market would assume a percentage of this figure as representing the profit that could be expected. The judge considered that this “rule of thumb” approach was of doubtful reliability because common sense suggests that net profit margins will vary, perhaps significantly, from case to case. He considered that the correct approach was to adopt a method that involved estimating the EBITDA for each arcade.
Having made this decision, the judge then examined the estimates of the experts for the various heads of income and expenditure before deciding on the most realistic, together with evidence of the ratio of actual or estimated EBITDA figures for similar transactions in order to determine the appropriate multiplier. He found that true combined value in 2007 should have been £3.5m instead of £4.2m, and that the defendant had acted as no reasonably competent valuer would have done by not attempting to estimate EBITDA . It was therefore negligent.
While it is easy to assume that these cases have little in common given the differences in subject matter and some of the valuation terminology and methods used, a closer study indicates that the approach of the judges was remarkably similar. In each case the court preferred the method that analysed and considered the variable inputs in greater detail. In ISN Software Corp this was DCF over DCCF; in Barclays v Christie, Owen Davies it was EBITDA over headline turnover. And having identified the preferred method, in both cases the judges showed no hesitation in using the evidence to apply them and reach a valuation that was very different to those being advocated by the experts.
The overriding lesson for valuers is that courts in countries that apply the principles of common law will take a dim view of valuations arrived at using short cut or “rule of thumb” methods unless there is irrefutable evidence that these are the predominant methods used in a particular market. They will put more weight on methods that examine variables and that allow these to be adjusted on a case by case basis, even if those inputs are based on reasonable estimates rather than hard data. And last, but not least, they are not afraid to step in and make a decision as to what those inputs should be.