How Courts View Valuation Methods In Appraisal
David F. Marcus
Joseph B. Doyle
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. 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
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. 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
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
Discounted Cash Flow (DCF)
Courts have long considered the DCF approach as a standard method for
valuing firms. 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. In fact, experts used DCF models in
14 of the 15 cases we analyzed. In 10 cases, the judges relied upon a
DCF model in forming their opinions.
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
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,” it is striking that
in the nine instances where multiples-based analyses were presented, the
judge rejected them in all but one case.
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.
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.
In our sample, judges sometimes criticized management projections for
They were not prepared in the ordinary course of business.
Management did not have a history of preparing them.
The firm consistently underperformed its projections in the past.
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
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.”
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
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
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].”
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
Inadequately similar comparable companies.
Insufficient number of adequately similar comparable companies.
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
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.
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,
David F. Marcus is a senior vice
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
 In re Appraisal of Dell Inc., Case No. 9322 (Del. Ch.).
 Chiappardi, M., “Investors Attack Key Expert in Dell Stock Appraisal
Fight,” Law360, March 2, 2016.
 Korsmo, C. and M. Myers, “Appraisal Arbitrage and the Future of Public
Company M&A,” Washington University Law Review, 92(6), 2015, pp.
 Andaloro v. PFPC Worldwide Inc., 2005 WL 2045640 (Del. Ch. Aug. 19,
 Andaloro v. PFPC Worldwide Inc., 2005 WL 2045640 (Del. Ch. Aug. 19,
 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).
 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).
 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
 Huff Fund Inv. P’ship v. CKx Inc., 2013 WL 5878807 (Del. Ch. Nov. 1,
 Merlin Partners v. AutoInfo Inc., 2015 WL 2069417 (Del. Ch. Apr. 30,
 In Re Nine Sys. Corp., 2014 WL 4383127 (Del. Ch. Sept. 14, 2014).
 Owen v. Cannon, 2015 C.A. No. 8860-CB (Del. Ch. June 17, 2015)
(brackets in original).
 Merion Capital LP v. 3M Cogent Inc., 2013 WL 3793896 (Del. Ch. July
 LongPath Capital LLC v. Ramtron Int’l Corp., 2015 C.A. No. 8094-VCP
(Del. Ch. June 30, 2015).
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