Delaware fair value case disputes “circular logic” when selecting size premia

The Delaware Chancery Court found the majority owners of a large, privately owned alcohol distributor authorized a merger to “freeze out” a 15% minority shareholder by using a process that was “anything but fair.” A fairness opinion, obtained a week prior to the merger, was an “afterthought,” the court noted, “pure window-dressing” to justify the majority’s objective.

In determining whether the merger price was fair, the court considered evidence from opposing experts. In their DCF calculations, both agreed that a size premium applied.  Both used Ibbotson data, but the majority expert selected 5.78% from the tenth decile and the minority expert chose 3.47% from the ninth to tenth deciles. The problem for the court went beyond a mere divergence of opinion, however.

Specifically, Ibbotson assumes “one already knows or has an estimate” of a company’s market cap before deciding which decile it falls into and then selecting the size premium, the court explained. When the company’s value is disputed and the DCF analysis is the proposed solution, “the appropriate risk premium cannot be taken as exogenous. That is, a [DCF] both values the size of a company (and thus points to the appropriate Ibbotson premium to use) and relies on the appropriate Ibbotson premium to determine the value of the company,” the court said, with emphasis. The process is circular; does the valuation of the company or the selection of the Ibbotson risk premium come first?

For the answer to the court’s question—and its perspective on the DCF analysis generally--read the complete digest of In re Sunbelt Beverage Corp. Litigation, 2010 WL 92519 (Jan. 5, 2010), in the next Business Valuation Update™; the full-text of the court’s opinion will be available at BVLaw™.  It’s a lengthy and thoughtful decision, and besides questioning the logic behind size premia, the court also opines on several other critical issues, including:

  • the company-specific risk premium (hint: the Delaware Chancellors are still highly skeptical without empirical, quantitative support);
  • the effect of a post-merger conversion S corporation (both experts adjusted their values upward, requiring the court to intervene “in a rare harmony”); and
  • what makes a comparable “truly comparable” under the market approach—.

Still a chance to register for free Duff & Phelps webinar

The 2010 Duff & Phelps Risk Premium Report, co-authored by Roger Grabowski and David King, arrives next week.  BVR has included two free bonuses for purchasers of this year’s Report. First, the 2010 edition comes with the Cost of Capital Reader—a free supplement that includes the latest articles and presentations on how to derive cost of capital calculations in this period of unique volatility.

As a second bonus—purchasers of the Report can attend “Duff & Phelps Report 2010: Learn from the Master,” a 100-minute teleconference hosted by Grabowski and BVR on February 18th  (registration is $99 for non-purchasers).  Grabowski will focus on this year’s expanded cost of capital measures for companies of all sizes, and the effect of the current markets on historical equity risk premiums (ERPs) and size premiums. 

Analysts from Grant Thornton and the AICPA cheap stock task force defend Black-Scholes

BVWire’s  “Does Black Scholes overvalue early-stage companies” (BVWire™ #88-3) and an article by the same name in the January 2010 BVUpdate brought many responses—including a particularly thoughtful one from Grant Thornton’s Scott Beauchene and Stillian Ghaidarov. They refute the concern that “the Black-Scholes Option Pricing Model (BSOPM) cannot be used due to the perceived differences in the distribution of outcomes compared with observed outcomes in venture databases,” and ultimately find that “lognormal distributions are not a reason to conclude that the OPM overstates common stock values.” They also provide a succinct overview of the lognormal model for asset prices, its foundation as well as the model’s implicit, theoretical “failure” and “success” probabilities. The alleged critique of the BSOPM “does not present a strong argument to completely abandon it,” the authors conclude. “To paraphrase a famous saying, all models are wrong but some are useful, and the BSOPM remains a valid and useful model for the equity allocation of early-stage companies.”

Their response—which includes input from Dave Dufendach and Neil Beaton along with select members of the AICPA’s current task force on cheap stock, appears in the next (March 2010) Business Valuation Update™.

Beaton is also the author of the just-published BVR’s Guide to Valuations for 409A Compliance, which contains a complete chapter on the application of acceptable pricing methods, including the current value method and all option pricing models, case studies and the application of discounts and other key adjustments. For an overview of the Guide, check out the table of contents.

Does the SEC ‘back-test’ fair value measurements?

"Fair value is here to stay," said James Kroeker, SEC Chief Accountant, during the opening day of the SEC Speaks conference in Washington, D.C. last week. (In an unprecedented move, day 2 was cancelled due to the winter storm that devastated the area).

But, FEI Financial Reporting Blog reports that former Commissioner Cynthia Glassman asked if the SEC has “back-tested” fair value amounts, i.e., "what they ultimately turned out to be worth, to see if it is an appropriate measure going forward.” Kroeker replied “that is something the Division of Corporation Finance considers in terms of its disclosure rules, what entities are doing to ‘backtest,’ if you will, fair value.” The objective is not one of using hindsight, he added, or “calling into question judgments reached” as of an earlier date. If an entity later sells the asset but the amount at which it is sold differs from the estimate, “that doesn’t immediately call into question the estimate.”

Values are constantly changing; but that does not automatically mean [the estimate was] wrong,” added Wayne Carnall from the SEC Division of Corporation Finance.  However, if the agency sees something “unusual,” Carnall added, it will ask “lots of questions” about compliance with FAS 157, and it the fair value measurements look “contrary to market expectations, we will certainly ask questions in that regard.”

Latest EOU adds new real estate and more historical trend data

In response to recent subscriber feedback, the Economic Outlook Update™ (EOU) has been enhanced with new data relating to the real estate market. Current (and future) editions of the quarterly EOU will now feature: real estate investment trust (REIT) returns reported by National Association of Real Estate Investment Trusts®; property index returns by the National Council of Real Estate Investment Fiduciaries; and current and forecasted figures from the National Association of Realtors®. The new data include:

  • Housing Affordability Index forecasts
  • 30-year fixed rate and 1-year adjustable mortgage forecasts
  • Home starts (single and multi-family), home sales and home price forecasts

To give appraisers and their clients a better perspective on historical trends, the EOU will also highlight current and historical VIX figures (a defined measure of S&P volatility), as well as current and historical Consumer Confidence Index and Consumer Sentiment Index figures.

ASA ‘recession-proofs’ its core BV curriculum

If you did a valuation at the end of last year—and you did it the same way you did it in the years prior to the current recession, “you came up with a very, very wrong number,” says John Barton, chair of the American Society of Appraisers (ASA) BV Committee.

The impact of traumatic economic crisis provided unusual motivation in the ASA’s regular effort to update their BV curriculum (which they try to do every five years). “Variables that drive practitioners’ judgments were going off the charts,” Barton says, in an interview with John Borrowman (Borrowman Baker LLP) for his latest online newsletter. “If practitioners just grab the risk-free rate or the equity risk premium and makes assumptions about beta and so forth, they could be coming up with a very wrong number.” So, revisions to the ASA’s BV 201 through 204 guarantee case studies and more advanced lessons in DLOM, volatility in cost of capital determinations, issues in pass-through taxation, valuing intangibles, and international cost of capital.

Barton observes that the basic body of knowledge for the BV professional doesn’t change, but the world in which that knowledge gets applied does.  The improved ASA courses strive to stay current.


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