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Discounting Cashflow The Gold Standard For Determining A Target’s Present Worth

Abstracted from: The Impact Of Modern Finance Theory In Acquisition Cases

By: Prof. Rutheford Campbell Jr.,University of Kentucky

Syracuse Law Review - Vol. 53, No. 1, Pgs. 1-56

Overview:

Identifies the most sound method of determining a corporation's present value. Points out judges' frequent preference for unsound alternatives, and explains the reason for judicial confusion.

Best valuation method.

In Weinberger v. UOP (1983), the Delaware Supreme Court held that courts, when calculating a corporation's present value in an acquisition case, may use any valuation method generally accepted by the financial community. The consensus among financial economists, according to scholar Rutheford Campbell Jr., is that an extremely accurate method is to discount the corporation's projected cashflows. Neither historical cashflow nor current net earnings computed according to GAAP are relevant. The discount rate is the sum of the risk-free rate of return­usually the return on government securities­and the risk premium. Financial economists disagree on how to compute the risk premium; however, historical information can furnish benchmarks for calculating it. For example, the average risk premium in the last 70 years ranges from 2.0% on corporate bonds to 13.7% on small corporations.

Other valuation methods.

The author explains methods that are alternatives to discounting cashflow, such as the asset-value method, which subtracts liabilities from the liquidation value of assets; the deal-value method, which uses the acquisition prices of comparable corporations as reference points; and the comparative-ratio method, in which reference points, obtained from comparable corporations that are actively traded but not being acquired, are the ratios of stock price to, inter alia, total revenue, book value, and earnings before or after deducting particular expenses. Final valuation might entail blending or choosing among the ratios. The weighted-average-value method requires choosing and then weighting different factors of value, such as asset, market, earnings, and dividend values.

Discouraging data.

The author’s analysis of 76 post-Weinberger acquisition cases from all jurisdictions shows that just 31% (although 49% of the Delaware cases) used the highly reliable discounted-cashflow method. Judges in 20% of the cases applied the less sound asset-value method, which substitutes the liquidation value for the going-concern value that Delaware courts have long required. In 30%, judges used a weighted-average value, although no acceptable standard for weighting the factors exists. Even courts that discount cashflow sometimes ignore modern finance theory by using historical cashflows, including cash expenses deductible under GAAP (e.g., interest and taxes) in projected cashflow, or by selecting unjustifiable discount rates. A partial explanation lies in the litigants' tendency to present huge amounts of valuation evidence, complicated, technical, and frequently including multiple valuation methods (sometimes from the same party) and testimony by dueling experts with impressive credentials. Most competent judges simply cannot sort through it and make intelligent choices. A related factor is that Weinberger gave courts such wide discretion in choosing a method that decisions cannot serve as precedents, so no common law on valuation has developed. Courts must interrupt this cycle by requiring strict adherence to the discounted-cashflow method.

Abstracted from Syracuse Law Review, published by Syracuse University, Syracuse, NY, 13244-1030. For information on subscribing, call (315) 443-3680;

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