The May 31 Delaware Court of Chancery decision In Re: Appraisal of Dell, Inc. highlights many of the valuation issues faced not only by the Chancery Court in post-merger disputes, but by many courts in all types of disputes over valuation.
In the Dell matter, the Chancery Court held that the fair value of Dell, Inc. was $17.62 per share in a going-private transaction in September 2013. This opinion of value by the Court was about 30% more than the transaction price of $13.78 per share. At first glance, the Court’s opinion of value was surprising, since it is greater than a transaction price derived through a year-long process involving competing arm’s-length proposals.
The story essentially begins In 2012, when Michael Dell approached Dell’s board about taking the company private through a management buyout (MBO), to be sponsored by one or more private equity firms. Before the eventual transaction, a special committee of Dell’s board retained two investment advisers and a consulting firm to assist in “shopping” the company during a 45-day “go-shop” period as part of the board’s due diligence.
One of the investment advisers contacted about 60 potential acquirers, which resulted in at least two credible offers to acquire the company. In September 2013 the shareholders approved a deal from one of the financial sponsors rather than one of the two bids obtained during the “go shop” period.
As part of the transaction, Dell obtained two fairness opinions which concluded that the transaction was fair “from a financial point of view.” But certain groups of shareholders dissented from the transaction and asserted their appraisal rights, believing the transaction price to be too low.
During the trial, both parties presented valuation experts, each one of which providing an opinion of the fair value of a share of common equity of Dell as of the transaction date. The petitioner’s expert in the case concluded that the fair value of Dell was $28.61 per share, while the respondent’s valuation expert concluded $12.68 per share. The court noted that “two highly distinguished scholars of valuation science, applying similar valuation principles, thus generated opinions that differed by 126%, or approximately $28 billion. This is a recurring problem.” The Court eventually concluded the fair value of Dell was $17.62 per share.
The Dell decision highlights why two reputable experts may differ about an opinion of value. First, experts must deal with how value is defined by the courts. In the Chancery Courts of Delaware, fair value is defined as: “the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with interest, if any, to be paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into account all relevant factors.”
Fair value is the value to existing shareholders just prior to the corporate action (in the case of Dell, the management buy-out) and should not include any value enhancement from the transaction itself.
The definition of value in a particular matter often leads the valuation expert to use certain specific assumptions and methodologies in performing the valuation. Two common valuation techniques often used to measure the fair value of an operating entity like Dell are the use of multiples of similar publicly traded companies (“the guideline public company method”) and a discounted cash flow method (DCF).
In a large going-private transaction like the Dell buyout, the share price of similar publicly traded companies may be affected by a competitor’s proposed MBO. As a result, the guideline public company method may include benefits from the proposed transaction which are contrary to the definition of fair value. As such, the DCF often becomes the primary valuation method, but supported by multiples of similar, guideline companies. In Dell, however, the court relied solely upon the DCF method.
The DCF has three basic components: the explicit forecast period of cash flows, cash flow after the forecast period, and the discount rate reflecting the risk of receiving the cash flows. The starting point of the discounted cash flow is typically forecasts prepared by management reflecting their expectation of the future. Courts tend to prefer prospective financial information (PFI) prepared at the same time in the ordinary course of business so that any potential biases in the assumptions are likely mitigated.
Next, the value contributed by cash flows after the first forecast period are often limited by using an assumption to reflect the overall growth in the economy in estimating these longer term returns.
The third component of the DCF is the selection of a discount rate to discount the cash flows to the present to reflect the relative risk of not achieving the forecasts. Academics continue to debate the assumptions which underlie the cost of capital. The cost of capital is typically used as a proxy for the discount rate in a DCF. The assumptions used by valuation specialists in the DCF can cause a wide variation in conclusions.
In the Dell case, the valuation experts assumed different weightings of debt and equity in estimating the appropriate capital structure of the company. Both experts also made different assumptions in the required return on equity, which were incorporated into their respective discount rate. The court, however, ignored certain assumptions used by both experts and computed its own discount rate.
In contemplating the MBO, Dell’s board retained an outside consulting firm to assist in preparing detailed forecasts of expected cash flows of the company. At the trial, both experts used the forecasts as a basis for their DCF. But the respondent’s expert adjusted the forecasts for the declines in market conditions from the time the forecasts were prepared in January 2013 to the transaction date, as well as a “transition period” to normal operations and stock-based compensation.
While courts traditionally prefer forecasts prepared at the same time, the court in the Appraisal of Dell concluded that the respondent’s expert’s adjustments to two specific sets of projections were reliable, although one was more conservative and the other more optimistic. In reaching its opinion of the share’s value, the court made adjustments to the experts’ discount rates and their assumptions regarding excess working capital and taxes. But the court used the respondent’s expert’s two adjusted forecasts. The Court gave equal weight to conclusions under both forecasts after other adjustments in its opinion that the fair value was $17.62 per share.
What can we learn about valuation from this opinion?
First, each situation is based on facts and circumstances. In Dell, the per share price of a publicly traded share of a company’s stock was determined not to be its fair value. Secondly, despite the company being presented to a host of potential acquirers, the eventual transaction price was determined to be not at fair value.
But fair value may be based on contemporaneously prepared forecasts if they’re deemed reliable. Finally, guideline companies and comparable transactions may also indicate fair value but also require detailed analysis to determine their reliability.
Mark L. Zyla is Managing Director of Acuitas, an Atlanta-based valuation and litigation consultancy firm. He is the author of Fair Value Measurements: Practical Guidance and Implementation 2nd ed., published by John Wiley & Sons in 2013.