Finding “True North” in Recent Delaware Appraisal Cases: Is It the Market or the Model?
Petitioners in Delaware appraisal cases must necessarily argue that fair value exceeds the deal price. In contrast, financial economists tend to view prices from a well-functioning market as “true north” when valuing a stock. Valuation models – such as a discounted cash flow (DCF) model – can be important tools, but are known to be sensitive to their numerous inputs. When such a model results in a valuation that is at odds with market prices, it is imperative to understand the disconnect: Is it the market or the model that is wrong? In this Q&A, Glenn Hubbard, Dean and Russell L. Carson Professor of Finance and Economics at Columbia Business School; and Andrew Metrick, Janet L. Yellen Professor of Finance and Management at Yale School of Management, consider this disconnect in the context of a number of recent decisions from the Delaware Chancery Court. The decisions appear to reflect a healthy skepticism of DCF models that produce valuations far above deal price without a compelling explanation for the valuation gap.
Q: What is your perspective on the market for corporate control in the context of valuation disputes?
Glenn Hubbard: Dean and Russell L. Carson Professor of Finance and Economics at Columbia Business School
Professor Hubbard: Takeover transactions can arise for a variety of reasons, including achieving synergies with the acquiring company or replacing existing management with a team that is presumably more capable of addressing the company’s challenges. In nearly every case, the target firm receives a premium to their unaffected market price, indicating a higher valuation by the bidding firm. Several decades of research show that these transactions typically provide large gains in combined value, most of which accrues to the target firm. The fact that bidding firms generally do not see large gains is consistent with a competitive market – targets are able to extract full-value bids. In an appraisal context, a competitive M&A market means the deal price is a natural starting point for assessing fair value.
Q: As an economist, what is your view of fair value?
Professor Metrick: A standard definition of value is the price at which buyers and sellers agree to exchange an asset. So in that spirit, a market price is a very good place to start. Of course, there are valuation tools such as a DCF model or a market multiples approach that can provide alternative measures of value, but these depend critically on the inputs and assumptions. The stock market price reflects the judgment of many investors.
Q: Can the stock price provide a reliable measure of fair value?
Professor Hubbard: Whether the unaffected stock price is a reliable measure of fair value depends on the facts and circumstances. Fair value under Delaware General Corporate Law [§262] gives consideration to information that is known within the firm but not by outside investors. Therefore, to the extent that the stock market price reflects public (but not private) information, there is potentially a gap between the stock market price and fair value. This gap could be positive, negative, or zero, depending on the nature of the private information. In addition, there is a timing issue – fair value in an appraisal is measured as of the merger close, whereas the unaffected market price is measured prior to the merger announcement. Adjusting for the information that occurs during the period between signing and closing could result in a valuation that is higher or lower than the unaffected price. The Chancery Court recently used the unaffected price as the most reliable indicator of fair value in Aruba.
Q: What sort of arguments do petitioners tend to make to explain why a deal price was far below fair value?
Professor Hubbard: When petitioners advance a valuation above deal price, they are saying there was money left on the table. Of course, if multiple bidders are competing to buy the target firm, we would not expect to see the target leave significant money on the table. In Dell, for example, petitioners put forth a valuation that was about $26 billion above the deal price. Petitioners often point to various perceived flaws in the sale process that might hinder competitive bidding. Potential flaws could include the lack of a pre-market canvass, restrictive deal protection terms such as break fees, and match rights. They may argue there was an unlevel playing field (particularly in an MBO transaction) so the disadvantaged bidder(s) would not put their best offer on the table. At the end of the day, petitioners need to explain why another bidder would have been willing to pay more if the process had been run differently.
Andrew Metrick: Janet L. Yellen Professor of Finance and Management at Yale School of Management
Professor Metrick: Another category of arguments that petitioners make to explain a large valuation gap is the asymmetry between what management knows and what the bidders or outside investors know. One form of this argument is that management has plans that the market does not know about (or does not fully understand). An additional form of the argument that comes up most often with MBOs is that the company is currently undervalued by the market, perhaps because the price is depressed following a temporary downturn in its financial performance, leading management to opportunistically try to buy the company in a trough.
Q: Are there situations where fair value might be less than the deal price?
Professor Metrick: Fair value under Delaware §262(h) is “exclusive of any element of value arising from … the merger” such as synergies. Synergies often arise with strategic bidders, who may be able to achieve cost savings or revenue enhancements by combining the target firm with their existing business. For example, the Chancery Court determined that fair value was about eight percent below deal price in the SWS appraisal . Similarly, in AOL the court relied on a DCF model in determining that fair value was below deal price and noted that synergies could reconcile the difference.
Professor Hubbard: While it is common to think of synergies in the context of a strategic buyer with business operations that overlap with those of the target firm, financial or tax synergies may also be important in other transactions, including those involving private equity. The recent Solera ruling adopted my opinion that fair value was the deal price less synergies. Solera was acquired by private equity firm Vista Equity Partners, which had some financial synergies resulting from adding leverage, as well as some operational synergies arising from other portfolio companies that overlapped with Solera.
Q: Cash flow projections are obviously a key input into a DCF model. How does the court approach projections when the opposing experts begin their valuations with different cash flows?
Professor Hubbard: My approach, which I think is consistent with the court’s preference, is to start with management projections. But they cannot be accepted blindly. For instance, in Dell the projections that appeared in the proxy were prepared in late 2012 based on a detailed model that built off of projections for global PC sales from an industry source. By the time the deal closed, nine months later, industry forecasts had declined significantly due to trends such as tablets and smartphones replacing computers. In order to reflect Dell’s “operative reality as of the merger date,” I used the most recent industry forecasts to update the cash flow projections. The court noted its general skepticism of adjustments, but found that I had “persuasively justified” my changes and used them in its DCF model.¹
Q: What are the key considerations in determining the terminal value in a DCF model?
Professor Metrick: The terminal value calculation, which captures the value of all cash flows beyond the explicit forecast period (say five years), often constitutes the vast majority of a company’s value. There are really three inputs the valuation expert must provide in this calculation: the discount rate, the terminal growth rate, and the assumption about how much investment is needed. While the discount rate can have a large impact on the valuation (higher discount rates result in lower valuations), that input seems well understood.
The growth rate and investment rate assumptions are (or at least should be) linked. The critical insight is that growth is not free and that firms need to invest to grow. My approach to calculating terminal value links investment to growth. Increasing the growth rate increases investment (and therefore decreases cash flow). The DCF model that I used in PetSmart incorporated this approach. In its opinion, the Court stated that it was “convinced that Metrick’s formula for calculating the required amount of investment to support the terminal growth rate is proper, as it is supported by economic theory [and] finance literature.”² ■
- Dell, pp. 102–103.
- PetSmart, p. 105.