VALUING EQUITY IN DELAWARE CORPORATIONS IN MERGERS AND ACQUISITIONS:
AN ANALYSIS OF THE ACCEPTED VALUATION METHODS
SUBSEQUENT TO THE WEINBERGER RULING
 

Dave Marsh
 

Law & Valuation
Professor Palmiter
Spring, 1999



 
 

Text of Paper

 


 
Abstract

Valuation of the equity shares of both publicly and privately held corporations is extremely subjective and difficult.  There is no single formula for determining the valuation and several different methods are used.  Delaware courts are faced with the problem of valuation of corporations frequently because of the state’s favorable incorporation statutes.

ISSUE

What methods are used by Delaware to determine the value of equity shares of a corporation?
RULE
Some common methods include the discounted cash flow method, comparable company approach, net asset value method, EBITDA multiplier, price/book multiplier, sales multiple approach, and the dividend discount model.

ANALYSIS

 
Before 1983 and the landmark case of Weinberger v. UOP, Inc., Delaware exclusively used the Delaware Block Method.  Under this approach, three elements of value were examined, which were market value, asset value, and earnings value.  These values are then averaged in order to determine the fair value of the equity of the company. However, the problem with this approach is that each element is weighted, and this weight is arbitrarily determined.  In the Weinberger case, the plaintiff used an investment analysis, who used two types of analysis.  The court stated that these methods were not in accord with the Delaware Block Method, but since this method excluded other methods, then it was outmoded and its exclusive use should be abandoned.  Also the court found that the fair value should evaluation the business as a going concern, rather than using a prospective merger as the key for determining value.


One of the methods used by the plaintiff’s expert was the discounted cash flow method, which was rejected by the court, but is now quite common in valuation cases.  The DCF method requires the appraiser to make many assumptions to determine a per share value of the equity of a corporation.  First, the cash flow of the company is projected for a specific number of years in the future.  Then the terminal value of the firm must be calculated, which projects the cash flows infinitely into the future, using the long-term growth rate and discounting by the discount rate minus the risk free rate.  The firm’s cost of capital is also used as the discount rate, which is determined using either the capital asset pricing model or the weighted average cost of capital, depending on the capital structure of the firm. Once this has been determined, it is applied to the projected cash flows to determine the fair value of the firm. Although this method is widely accepted, it has negative aspects.  First any change in the market risk premium can significantly alter the net present value of the projected future cash flows.  Second, any error in estimating the company’s sales revenue and gross margin growth can also impact the valuation. Many estimated values are used in this method, which can lead to significant differences between appraiser’s conclusions.
 

A second method being used is the comparable company approach.  This involves comparing the firm being valued to similar companies.  One way this can be done is through comparing valuation ratios.  The most common ratio used is the price earnings ratio.  Examining this ratio of comparable firms allows the analyst to determine the price that minority shares would trade for if they were valued similarly to the comparison company.  The price paid in mergers and acquisitions of comparable companies is also useful to determine a fair price for the company being valued.=

Another method is the net asset value method. This attempts to value common equity on the basis of the fair market value of the firm’s net assts.  However, this method has been frequently rejected because it does not value the firm as a going concern, thus undervaluing intangible assets, such as goodwill, as well as not taking into consideration the future earnings potential of the equity.  However, if it is inevitable that the firm will be dissolved, this approach is acceptable.

New methods are being developed continuously.  One new method is the EBITDA multiplier.  This involves comparing the market price and EBITDA of comparable firms and using this to calculate the appropriate EBITDA multiplier for the firm being valued.  The price/book multiplier is another such method, only using the price/book multiplier instead of the EBITDA.  A third new method is the sales multiple approach.  This involves comparing an average sales multiple for comparable firms and then uses this to determine whether the firm’s per share market price is fair. This is most commonly used for the new technology companies.  A final method is the dividend discount model, which projects a firm’s dividends into the future and discounts them at the firm specific rate.  This is not commonly used in Delaware, and is not greatly supported.

Thus, there are numerous valuation methods that can be used, in Delaware and anywhere else, to determine the value of the equity shares of a corporation.


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Introduction

Valuation of the equity shares of any corporation, whether it is publicly traded or privately held, is one of the most subjective and challenging tasks the courts in Delaware will ever deal with.  This issue is most commonly contested in appraisal actions pursuant to Title 8, section 262 of the Delaware Code.  Appraisal rights attempt to preserve the rights of minority shareholders to receive "fair value" for their holdings in the event of a corporate merger or consolidation.  Even financial professionals view the process of determining the fair value of equity as one of the most daunting tasks that they must face during the course of their careers.  The single biggest reason that this task is so challenging is the fact that there is no single prescribed formula that is most effective for valuing the common equity of every company.  All companies face what financial professionals refer to as firm-specific risk, which makes valuing each and every company a unique challenge.  In addition, as technological advances lead to new business models, financial professionals are constantly developing new valuation methods to estimate the fair value of a firm's common equity.  This issue will likely continue to be a very controversial one for the courts to manage.  The courts of Delaware should expect to see a disproportionately large number of cases centering on this issue due to Delaware's favorable incorporation statutes.


History of Equity Valuation in Delaware: The Delaware Block Method


 
Prior to a landmark decision in 1983 in the case of Weinberger v. UOP, Inc., the courts of Delaware exclusively used what is referred to as the Delaware Block Method for equity valuation.  Under the Block Method, three elements of value were generally given major consideration: market value, asset value, and earnings value.[1]  Once these three values are determined, the appraiser takes a weighted average of the three measures in order to derive the fair value of a company's common equity.  The biggest problem with this method, however, is that the weight given to each element is arbitrarily determined by the appraiser.  Thus, even under the Block Method, there was a strong possibility that the plaintiff and defendant would come up with extremely different values for the equity and that both sides would exclude important information such as growth potential, which could significantly alter the value of the common equity.
In the Weinberger case, the plaintiff hired a charted investment analyst to offer alternative valuation methods to show that the price he received for his shares was too low.  The analyst used a comparative analysis of the premium paid over market in ten other tender offer-merger combinations, and a discounted cash flow analysis to estimate the value of Weinberger's common equity.  The Chancellor in this case stated that the plaintiff's valuation techniques clearly were not in accordance with the Delaware Block Method, which had been accepted in the courts for decades.[2]  The Chancellor went on to say, however, that the Block Method excluded other generally accepted techniques used in the financial community and the courts and was therefore clearly outmoded.  He also said it was time we recognize this in appraisal and other stock valuation proceedings and bring our law current on the subject.[3]  Although the Justice rejected the discounted cash flow analysis prepared by the plaintiff's expert, the court abandoned the Block Method as the exclusive means of establishing fair value.  This opinion is undoubtedly largely responsible for the tremendous rise in appraisal proceedings in the Delaware courts.  However, it is revolutionary in that it exhibits the willingness and desire of the courts to protect minority shareholders and to keep pace with the constantly evolving financial community.
In addition to enlightening the legal community with regard to alternative stock valuation methods, the opinion in the Weinberger case also upheld the opinion that shareholders are entitled to receive fair value for their shares.  This fair value is to be determined as the shareholder's interest in a going concern.  Therefore, the valuation should not take into consideration a prospective merger as a key value driver, but rather, should evaluate the business as a going concern.


Discounted Cash Flows (DCF)

When Weinberger's expert brought his discounted cash flow (DCF) valuation method before the court in the early 1980s, the Justices presiding over the case rejected the valuation method.  Today, it is perhaps the most commonly accepted valuation method in the Delaware courts.  In fact, one judge's opinion stated that the DCF method of valuation is considered by experts to be the preeminent valuation methodology.[4]  The DCF model is also one of the most commonly used valuation techniques employed by investment banking professionals when valuing common equity.
The DCF model requires the appraiser to make many assumptions and projections in order to establish a per share value for a company's common equity.  First, the appraiser must project the firm's cash flows for several years (generally at least three) into the future.  These projections are, themselves, subject to a good deal of uncertainty due to the unpredictable nature of the business cycle.  Once the appraiser completes this process, the next step involves calculating what is referred to as the terminal value of the firm.  This terminal value projects the firm's cash flows infinitely into the future.  The flows are projected forward using the firm's long-term growth rate and discounted by the firm's discount rate less the risk free rate.  In financial nomenclature, terminal value is calculated as follows:
Terminal Value = ((NI + Depr. - Cap. Ex. +/- Changes in NWC) * (1 + g))/(E(r) - R(f))

 
Where:

NI = net income

NWC = net working capital (generally current assets - current liabs.)
g = firm's long-term growth rate
E(r) = expected return for the firm (generally determined using WACC or CAPM)
R(f) = the risk-free rate (generally the prevailing yield on 30-yr. U.S. Treasury bonds)


As alluded to in the preceding discussion of terminal value, the other key variable needed to utilize the DCF model is the firm's cost of capital.  The firm's cost of capital becomes the discount rate used to discount the projected cash flows.  If the firm's capital structure is comprised solely of equity, the cost of capital can be found using the capital asset pricing model (CAPM).  If the capital structure is comprised of a combination of debt and equity, the appraiser must use the firm's weighted average cost of capital (WACC) as the discount rate.  Once the appropriate discount rate has been determined, it is applied to the projected cash flows to derive the fair value of the firm.

Although the DCF valuation method has now gained wide acceptance in Delaware courts, it is not without some inherent flaws.  First, a one percent change in the market risk premium used to determine the firm's cost of equity could significantly alter the net present value of the projected future cash flows.  Second, any over- or underestimation of the firm's sales revenue and gross margin growth can also have a significant impact on the valuation.  Unlike some of the other methods, which will be discussed shortly, the DCF valuation method is replete with many estimated values that give rise to considerable margin for differences in per share price.   As "expert" appraisers are called to testify on both sides in appraisal proceedings, two experts can use the same DCF approach and many of the same estimates, and still end up with per share values that are very far apart.  For instance, in the case of Cede & Co. v. Technicolor, Inc., experts on both sides used the DCF method, but developed different assumptions about how the business would operate and perform in the future.[5]  The value derived by Cede's expert was $62.75 per share versus a value of $13.25 per share derived by Technicolor's expert.  In a similar case, Salomon Brothers, Inc. v. Interstate Bakeries, the justice dismissed the DCF valuations of both experts, citing unfair client bias by both appraisers.[6]  In these cases, the judge is often left to wade through the biases of the two parties and attempt to establish some fair market value for the shares.  In the case of Hintmann v. Weber, the judge went so far as to evaluate each input used in the DCF valuation approach in order to establish, what he felt, was fair value.[7]  These cases demonstrate how sensitive the DCF model is to different assumptions regarding the future growth opportunities of a business.

Comparable Company Approach

Aside from the DCF model and the Delaware Block Method, which still has credibility as an alternative valuation technique, the courts are becoming more receptive to methods of valuation based on a comparison to other comparable companies.  This approach includes several different methods for comparing the value of a company versus its peers.  First, experts can look at key valuation ratios of other comparable companies and apply those ratios to the company they are valuing.  Second, experts can look at the premiums paid to comparable companies when they were bought out in acquisition or merger proceedings, and apply a similar premium to the pre-merger price of the firm they are valuing.

Investment banking professionals use a variety of valuation ratios to compare the market prices of the equity shares of comparable companies.  Perhaps the most well recognized of these ratios is the price earnings ratio.  The market price of a firm's common equity is often analyzed with regard to the P/E multiple at which it trades in the market.  For instance, if a company earns $1.50 per share during the year and trades in the market on the day its annual earnings figures are announced at a price of $30 per share, the stock is said to trade at a P/E multiple of 20 times earnings.  If this company is in the same line of business as a company being valued in an appraisal proceeding and has a similar capital structure and other similar characteristics, an analyst may apply this company's P/E multiple to the earnings of the firm he/she is analyzing.  This permits the analyst to derive the price at which the shares of the firm being valued in the proceeding would trade if they were valued similarly to the comparable company.  Often, there are several competitors in the same line of business as the company being valued.  In these cases, it is the analyst's charge to determine which competitors are most similar to the company being valued in the appraisal proceeding and derive an average P/E multiple from those companies that are most comparable.  Then, the analyst would apply this average P/E multiple to the firm being evaluated and come up with a fair market value in this manner.  Again, this valuation method is subject to the analyst's opinion as to which companies represent the best comparable companies with which to compare the firm being evaluated in the appraisal proceeding.

Another method used in the investment banking community, which has received some recognition in the courts involves analyzing the premium paid in mergers and acquisitions of similar companies and applying a similar merger premium to the company being valued.  This valuation method gained recognition in the Shell Oil appraisal proceeding.[8]  In this case, the appraiser for the plaintiff offered what was termed a Comparative Deal Market Analysis.  He analyzed the premiums paid to the shareholders of other oil companies that were acquired, such as Gulf and Conoco, and applied a similar premium to the price of Shell's shares to derive his fair market value.  After comparing the transaction at issue in the Shell case with 17 other industry acquisitions, he established a fair price for the Shell shares at $106.  The defendant's exert, Morgan Stanley performed a similar analysis and arrived at a value of $60 per share.  Although the Chancellor did not fully accept all of the assumptions made in either of these two analyses, he did state that this was "an acceptable method for evaluating a corporation like Shell."  Again, this exhibits the court's willingness to consider all relevant information when attempting to determine the fair value of a firm's common equity.

 

Net Asset Value – A Liquidation Approach
Another potential valuation method, the net asset value method resembles the liquidation value approach to determining equity value.  The net asset value method, much like the liquidation approach, attempts to value the common equity on the basis of the fair market value of the firm’s net assets.  Net assets are computed as total assets minus total liabilities.  The valuation technique attempts to ascertain the fair market value of the assets, deducts the book value of the liabilities, and determines a value per share based on the residual value, termed net asset value.

In general, the courts have recently rejected this approach in most cases because it does not value the firm as a going concern.  For instance, in TV58 Limited Partnership v. Weigel Broadcasting Co., the judge rejected an asset value approach prepared by Merrill Lynch.[9]  Despite the fact that Merrill Lynch is one of the most highly respected investment banking firms in the U.S., the judge stated, “While a cost (or “asset value”) approach may occasionally be appropriate in valuing a going concern, it tends to undervalue intangible factors of a business (i.e. goodwill and synergy).”  As stated by the judge in this case, the biggest flaw associated with this approach is the fact that the shareholder is not compensated for the future earnings potential of the entity.  Other intangibles, such as brand names and human capital, can often be the most valuable assets a firm has.

Occasionally this approach is the best valuation method available and in such cases, the court has accepted it as a valid and acceptable approach.  For example, in cases where it is inevitable that the firm will be dissolved, the net asset value approach, or the liquidation approach are often the estimators of fair value.  However, it should be noted that this approach is being rejected by the court more often as more sophisticated valuation methods are being developed and used in the financial community.
Other Valuation Approaches – An Evolving Discipline

 


Securities analysts often use a variety of other multipliers to compare the market value of comparable firms.  In
addition, with the recent growth in public offerings among high technology companies, common equity valuation is becoming more and more challenging.  Investment banking professionals are constantly looking for new models that help project the “fair value” of a firm’s equity.
A. EBITDA Multiplier

One of the more common contemporary valuation methods used to value common equity is the EBITDA multiplier.  This is a comparable company approach, similar to the P/E valuation approach.  It is particularly useful in valuing firms that have negative earnings per share, but positive income from operations.  Under this method, the analyst examines the market price of comparable firms and determines how the market value compares to the firms’ EBITDA.  In other words, the analyst multiplies a firm’s market value per share by shares outstanding, then divides this figure by the firm’s EBITDA.  Once a suitable group of comparable companies are analyzed in this manner, the analyst can calculate an appropriate EBITDA multiplier and apply it to the firm being evaluated.  Analysts evaluating telecommunications and high technology companies often use this method.  For instance, a majority of the sell side analysts that follow Cox Communications commonly use this valuation method to project the fair value of the firm’s equity.

B.  Price/Book Multiplier

Often used by analysts to support other valuations, the price/book multiplier approach is similar to the other comparable company approaches previously described in this report.  Under this valuation approach, the analyst evaluates a group of comparable companies and determines the price/book multiple at which their common equity sells in the market.  The analyst is responsible for carefully selecting the comparable companies. Once the average price/book multiple of the comparable firms has been determined, the analyst applies that multiple to the firm being evaluated in the proceeding.  Although this sounds like a trivial and extremely simple approach to valuing common equity, it has obtained wide support in the financial community and it represents a figure that is quoted often by securities analysts.

C.  The Sales Multiple Approach

This valuation method has emerged in the financial community due to the highly volatile high technology companies, including publicly traded Internet firms.  Essentially the analyst divides the market value of a firm’s common stock by the firm’s annual sales revenue figure in order to determine the firm’s sales multiple.  Much like the other comparable company approaches, the analyst surveys the competitive landscape for comparable competitors and computes an average sales multiple for the various firms.  The analyst then applies that multiple to the firm being analyzed in order to determine whether the firm’s per share market price is fair.  While this approach is far less widely accepted in the financial community, many high tech analysts cite the approach as one of the few ways to value these rapidly growing new companies, which have negative earnings per share.

D.  The Dividend Discount Model

Although it has been supported in academia for a long time, the dividend discount model is rarely used in the financial community as the sole measure of equity value.  This model projects a firm’s dividends into the future and discounts them at the firm specific discount rate.  There do not appear to be any cases in Delaware that have used this valuation technique, much less any instances where the court accepts it as a valid valuation approach.  Equity analysts lend the approach little support and prefer to use the DCF and other comparable company valuation techniques.

E.  Other Potential Valuation Approaches – The Future of Equity Valuation

It is difficult to project what valuation techniques will emerge in the future.  As Internet companies continue to issue common equity, the analysts’ job becomes increasingly difficult.  It is not unreasonable to expect analysts to develop new valuation techniques in order to project fair value.  For instance, since web sites measure the number of hits they receive on a continuous basis, one possible approach to valuing these companies in the future is developing a “number of hits” multiplier.  Although this approach sounds outrageous, how did the DCF approach sound to the courts 40 years ago.

Conclusion
While this report barely scratches the surface of the valuation techniques used in the financial community, it gives some insight into the difficulty that persists in valuing the common equity of a corporation.  The courts in Delaware have been very progressive in the last 15 to 20 years with regard to accepting valuation methods that are used in the financial community.  As case law evolves, it is likely that more valuation techniques will find acceptance in the Delaware courts as good estimators of fair value.  However, valuation of a corporation’s common equity will remain one of the most challenging tasks an investment banker will face in his/her career.

[1]Levin v. Midland-Ross Corp., Del. Ch., 194 A.2d 50 (1963)
[2]In re General Realty & Utilities Corp., Del. Ch. 480, 52 A.2d 6, 14-15 (1947)
[3]Weinberger v. UOP, Inc. Del. Ch., 457, A 2d 701 (1983) (Opinion by Justice Moore)
[4]Neal v. Alabama By-Products Corp., Del. Ch., 588 A.2d 255 (1991)
[5]Cede & Co. v. Technicolor, Inc. Del., 684 A.2d 289 (1996)
[6]Salomon Brothers, Inc. v. Interstate Bakeries Corp., Del. Ch. Civil Action No. 10,054 (1992)
[7]Hintmann v. Weber, Del. Ch., C.A. No. 12,839-NC, (1999)
[8]In re Shell Oil Co., Del. Ch., 607 A.2d 1213 (1992)
[9]TV58 Limited Partnership v. Weigel Broadcasting Co., Del. Ch. Civil Action No. 10,798 (1993)