Editor’s note: The author of this article is employed by valuation and corporate finance advisor Duff & Phelps, the largest provider of fairness opinions for M&A transactions. The content of the article should be viewed in that light.
The fairness opinion — a professional analysis of the fairness of a price offered in a proposed merger or acquisition — is a standard and widely utilized element of corporate governance. Managers and boards rely on independent fairness opinions to help assess transactions and fulfill their fiduciary duties.
Still, periodic criticisms about the utility of fairness opinions persist — in particular, that the analyses produce valuation ranges too wide to provide meaningful information. Also, it’s said, because most fairness opinions are based in part on analysis of discounted cash flow, or DCF, the opinions are too reliant on financial projections that are produced by management and not scrutinized by fairness advisors.
We agree that narrower valuation ranges are, intuitively, more useful to boards than wider ranges. However, some deals are likely to produce wide ranges because the companies themselves are difficult to value. The real question is whether wide ranges are pervasive.
And while we would also agree that relying solely on DCF analysis (which uses projections company management has fed to the fairness advisor) can be problematic, the follow-up should be to ask: Is that really happening?
In an effort to assess the overall usefulness of fairness opinions, Duff & Phelps analyzed more than 3,000 fairness opinions filed with the SEC during the 10-year period ending in 2016. Specifically, we looked at forms 14D and DEFM14A, which companies are required to file when they are the target of a purchase offer or require a shareholder vote.
Our analysis showed that on average, fairness opinions offer valuation indications that fall within 15 percentage points on either side of a midpoint — a standard that can serve as a benchmark for comparison. If a fairness opinion’s estimate falls outside the average valuation range against the offer price for similarly sized deals, managers and directors should be empowered to ask more informed questions, which can only improve the process of deliberating a purchase offer.
Among deals we analyzed that carried a value of $10 billion or more, DCF analyses produced average price ranges between 78% and 106% of the offer price. The average range widened only slightly for deals valued at less than $10 billion but more than $100 million. For deals valued at less than $100 million, DCF analyses produced average price ranges between 65% and 105% of the offer prices.
That there are wider and more disperse valuation ranges for smaller companies is not all that surprising. It reflects the heightened complexity involved in valuing enterprises that are less mature, have less historical data to analyze and compare, or are growing at a rate that could produce dramatic variances in expected cash flow.
In addition, voluminous published analyses, including Duff & Phelps’ Valuation Handbook — Guide to Cost of Capital, have shown that discount rates decrease as company size increases due to the diminishing effects of small-stock premiums. That research helps explain our finding that micro-cap companies receive the broadest valuation ranges.
And for the minority of fairness analyses that fall outside of these precise ranges, it’s important to note that not all companies fit neatly into valuation models, and deals are not all structured the same way. When fairness opinions account for such unique factors, we would expect them to produce price ranges that stray from the average.
The research findings present clear signs of an industry standard at work among fairness-opinion advisors. Counter to the criticism that fairness opinions rely too heavily on DCF analysis, we find that fairness advisors have been using multiple methodologies for some time. Ninety-one percent of the fairness opinions we reviewed used more than one methodology to arrive at valuations. In 75% of the deals, advisors used three or more methodologies.
We argue that the use of multiple valuation methodologies also significantly mitigates the criticism that opinions could be too heavily influenced by unrealistic company projections. The common pairing of public-company comparables and/or precedent transactions with DCF analyses, often supplemented by one or more additional methodologies, demonstrates that fairness-opinion advisors consider multiple perspectives and relevant analyses, when available, in assessing the fairness of transaction prices.
Using multiple valuation methodologies also dispels the notion that fairness advisors do not scrutinize management projections. Simply put, if the DCF analysis produced a valuation range that bore little resemblance to a range of values derived from other methodologies, that would be the first clue that something might be amiss and thus warrant a closer look.
After all, if the public peer group or the set of precedent transactions is sufficiently comparable, valuation multiples derived from these techniques can, in many cases, provide an inherently more objective view of valuation.
Further, the data we collected showed that overall the public-company comparables and DCF analyses produced relatively consistent ranges that were reasonably narrow, particularly for larger companies where more information was available.
The consistency of the average valuation ranges across DCF and public-company comparables analyses confirms the rigor and validity of both methodologies. When done correctly, neither examination is mechanical, and both illuminate appropriate valuation ranges to boards and special committees.
In 43% of the filings we analyzed, fairness-opinion advisors used multiple cases of DCF analyses. The frequent use of multiple DCF scenarios indicates that advisors are considering every potentially pertinent projection, rather than simply accepting a single set of forecasts.
In addition, the presentation of two (or more) DCF scenarios is likely the result of a growing judicial emphasis — via suggestion and mandate — on disclosure.
Companies today are less likely to pick and choose which projections to disclose than they were a decade ago. Those that counsel boards of directors may conclude that erring on the side of complete disclosure — even if a certain forecast included in regulatory filings was prepared for a much different purpose than assessing fairness — is generally prudent for the filer.
Our analysis indicates that the occasions that draw public scrutiny of fairness opinions are outliers, typically owing to peculiarities in circumstances more than to faults in the process.
We don’t expect our study to put an end to the debate around fairness opinions. We do believe it can help elevate that debate by injecting data where there has only been conjecture, by replacing the anecdotal with the empirical, and by better equipping boards to make informed decisions.
Christopher Janssen is global head of transaction opinions at Duff & Phelps, a global valuation and corporate finance adviser.