June 2015

A widely followed corner of the blog is our “Valuation Basics” series, where in earlier posts we have described many of the components of the discounted cash flow analysis, the income-based valuation methodology preferred by Delaware’s Court of Chancery.  (See here, here, and here).  Earlier this month we examined a market-based valuation approach — the comparable companies analysis  — that derives the subject company’s value based on the share price of analogous publicly traded companies.  Working knowledge of these and other valuation methodologies is essential for both appraisal professionals and professional investors, since as the Court of Chancery recently described in Merlin Partners LP v. AutoInfo, Inc., enterprise value can and will be determined in an appraisal proceeding a variety of ways, “depending on the case.”  Readers of our “Valuation Basics” series should check back in for the next post in that series, which will examine another market-based approach to valuation, the precedent transactions analysis.

As reported in Law360, stockholder Merion Capital LP petitioned the Delaware Chancery Court this week for an award of $67 per share for its stock in BMC Software, Inc.  Such a demand would reflect a 45% premium to the merger price of $46.25.  Indeed, as Law360 reported, the parties’ arguments focused to a large degree on how much deference should be accorded, if any, to the sale process and resultant merger price it produced.  The court also asked the parties for supplemental briefing on any purported synergies that BMC claimed to have achieved in the merger, which synergies are excluded by the appraisal statute from the fair value determination.   Readers may recall that we previously posted about the BMC case back in January, when Vice Chancellor Glasscock issued his decision in this matter as well as the Ancestry.com case, reaffirming the validity of appraisal arbitrage for the first time since the court’s 2007 ruling in Transkaryotic.

We will continue to monitor this case and post the court’s decision when available.

Our “Valuation Basics” series has focused on the various components of a discounted cash flow analysis under the income approach, which seeks to value a company based on the present value of its projected cash flows.  This post and those to follow in this series will now move away from the income approach and instead examine two “market” approaches: (1) the comparable companies method; and (2) the precedent transactions method.  Under these approaches, we look at how the market values similar companies in order to determine the value of the subject company.

The purpose of a comparable companies analysis is to derive a value for the subject company based on the stock price of similar publicly traded companies.  Accordingly, the first order of business is to select publicly traded companies that are “comparable” to the subject company.  No two companies are truly identical, so an appraiser must use her judgment to select companies that have sufficiently similar characteristics to the subject company from which meaningful valuation data can be extracted.  The more similar the selected companies are to the subject company, the more weight the court is likely to place on a comparable companies valuation.

After selecting the applicable comparable companies, valuation multiples are derived for each of the comparable companies by dividing their respective enterprise values (“EV”) by appropriate financial metrics, such as revenue or EBITDA.  The comparable companies’ stock price on the valuation date is used to calculate their enterprise value.  So, for example, assume that Comparable Company A has a stock price on the valuation date that yields an enterprise value of $2 billion.  Assume further that Comparable Company A has reported revenue for the last twelve months (“LTM”) of $500 million.  Comparable Company A’s LTM EV/revenue multiple would be 4.0.

Next, the valuation multiples of the comparable companies should be adjusted to account for differences between the comparable companies and the subject company.  For example, if the comparable companies have a large amount of outstanding debt but the subject company is debt free, the valuation expert might adjust the valuation multiples to account for the subject company’s more attractive balance sheet.  In our example, if the median LTM EV/revenue multiple of Comparable Companies A, B, C, and D is 3.8, the appraiser might select an LTM EV/revenue multiple of 4.0 to apply to the subject company if there are factors warranting an upward adjustment based on the subject company’s superior performance.

Once the appraiser has determined the correct valuation multiples, those multiples can be applied to the relevant financial metrics of the subject company to calculate the market value of invested capital of the subject company.  Using our example above, if the subject company had reported revenue of $750 million for the previous year, its market value of invested capital based on the LTM EV/revenue multiple of 4.0 would be $3 billion.  To derive the equity value of the subject company, the subject company’s interest-bearing debt should be subtracted.

Appraisal experts typically adjust a comparable companies valuation to account for the inherent minority trading discount reflected in the valuation multiples.  The stock price that is used to derive a comparable company’s enterprise value is based on transactions involving non-controlling ownership interests traded on the stock market.  Accordingly, the Delaware Court of Chancery has allowed appraisers to correct for this lack-of-control discount by adding a premium to the equity value derived from a comparable companies analysis.  While there is no set premium, the Delaware Court of Chancery has accepted as appropriate a premium of 30%.

In recent years, the Delaware Court of Chancery has become more exacting in its acceptance of comparable companies valuations in appraisal cases.   In cases where the court has rejected a comparable companies valuation proffered by a party’s expert, the court has often expressed its concern with the numerous subjective judgment calls made by the valuation expert in arriving at his comparable companies valuation.  Why did the expert choose some companies as comps but not others?  Why did the expert use certain multiples and not others?  Why did the expert adjust the selected multiple upward or downward rather than simply apply the mean or median multiple?  To address these concerns, valuation experts in appraisal cases should carefully describe in their expert reports not only the subjective judgment calls they made in conducting their comparable companies analysis, but also their principled basis for doing so.

In our next post in the Valuation Basics series, we will explain how the comparable transactions analysis differs from the comparable companies approach.

As reported in the Wall Street Journal, several investments funds who had exercised appraisal rights in connection with Albertsons’ acquisition of Safeway Inc. have now settled their appraisal case for a 26% premium over the merger price within just half a year after the deal closed.  The settlement, at $44 per share, netted $127 million more to the settling funds than the merger price of $34.92 would have given them.  While the deal resolves the claims of most dissenting stockholders, two other funds holding 3.7 million shares remain in the appraisal case, and the fiduciary duty class actions against Safeway remain pending as well.