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Discounted Cash Flawed (Part 2): Can An Expert Rely on Management’s Projections?

A previous GBQ newsletter analyzed a bankruptcy case involving the use of a discounted cash flow (“DCF”) analysis. Like the bankruptcy case, this decision involves a discounted cash flow analysis and, in particular, the use of management’s projections by an expert.

History of the Case

The dispute related to the acquisition of a biometrics technology company (Cogent, Inc.) by 3M Company (not a party to the dispute).  Cogent provides automated fingerprint identification systems technology and related solutions to government and law enforcement customers.  Cogent was founded in 1990 and its stock began trading publicly on the NASDAQ exchange in 2004.  In December 2010, after a two-plus year review of strategic options (including a sale of the company and multiple bidders in the sales process), 3M Company closed on its acquisition of Cogent at a price of $10.50 per share.

The Claim

In March 2011, former shareholders of Cogent filed a Verified Petition for Appraisal asking the Court of Chancery of the State of Delaware to value Cogent’s shares.  The former shareholders retained an expert who performed a DCF analysis of the value of Cogent’s shares (after rejecting other potential valuation approaches) and opined that the company was worth $16.26 per share.  3M Cogent retained its own experts who valued the company at $10.12 per share based on their own DCF analysis, a comparable companies analysis and a comparable transactions analysis (each equally weighed in the opinion of value).

Why the Experts Disagreed

In this case, the Court simplified the DCF model to three primary components:

  1. Cash flow projections;
  2. A discount rate;
  3. A terminal value (to account for the value generated during the period after the projection period).

As can be expected from the difference in results, the experts used different inputs in each of these three areas.

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The primary driver of the difference in outcomes was the significantly different bases for the cash flow projections – in particular, the higher industry growth rate and assumed acquisitions included in the former shareholders’ expert’s cash flow projections.  3M Cogent’s expert relied on management’s (and its advisor’s) five year projections that assumed a growth rate lower by 5% per year.

Previous Court cases had established that the Court preferred “valuations based on contemporaneously prepared management projections because management ordinarily has the best first-hand knowledge of a company‘s operations.”  However, previous cases had also identified factors that weighed against the use of management projections:

  • “Management had never prepared projections beyond the current fiscal year”
  • “The possibility of litigation, such as an appraisal proceeding, was likely”
  • “The projections were made outside of the ordinary course of business”
  • “The projections…were prepared by directors and officers of the target company who risked losing their positions if the…bid succeeded and were involved in trying to convince the Board to pursue a different strategic alternative in which [they] were involved.”

In this case, the Court weighed the facts that management had not previously prepared projections beyond the current year, the projections were prepared after the offer from 3M was received and with the assistance of its advisors against the use of the management prepared projections.  Alternatively, the Court had also “expressed skepticism with respect to projections prepared with the benefit of hindsight by testifying experts.”

The Court Rules

After holding a three day trial in November 2012, the Court issued its decision this past summer finding that the shares were worth $10.87 per share.  This result was obviously closer to the company’s valuation but represented the Court’s own valuation based on a combination of the assumptions and inputs used by each side’s experts (and did not consider the actual transaction price that the Court ruled was “largely irrelevant” to the proceedings).

Of particular importance were three determinations made by the Court:

  1. The Company’s expert’s purported comparable companies and transactions were disregarded by the Court because the companies or transactions were insufficiently comparable or too small in number to constitute a reasonable sample for valuation purposes (leaving only each side’s DCF valuations at issue).
  2. The Court ruled that the former shareholder’s projected cash flows based on industry trends was unsupported by the evidence because the company had historically underperformed the industry and that the use of cash for acquisitions approach was too speculative because the company had not previously completed any similar acquisitions.
  3. Based on the evidence presented and the Court’s preference for management projections, the Court ruled that management’s projections were a reliable starting point for the discounted cash flow analysis.

It is interesting to note that while the Court’s conclusion was at the end of the range calculated by the company’s experts, the Court on more than one occasion selected inputs used by the former shareholder’s expert.  In these instances the Court noted that his approach was “well supported and generally accepted by the financial community,” that he “demonstrated a stronger understanding of this subject and explained his methodology more convincingly” and was “the only expert who sought to justify his conclusion.”

Lessons for the Expert

Based on the Court’s rationale for its decisions regarding the use of the DCF in this case, a few observations can be made about damage analyses in general:

  1. Courts appear to prefer experts who clearly explain the bases for their assumptions and link the analysis performed to the facts and circumstances of the case.
  2. The use of comparable companies and transactions appears to be receiving more scrutiny as courts look more closely at specific characteristics (e.g., size, customers, products, etc.) of both the subject company and potential comparable companies.

Finally, unlike some other recent cases, there was no comment by the judge on the relative merits (or lack thereof) of the DCF compared to other valuation methods.  In fact, in this case, the Court used only the DCF to determine the value.  This case would appear to demonstrate that Courts will continue to accept DCF analyses but will also expect assumptions and inputs to be well supported, generally accepted and convincingly justified.

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Hock
Contact
  • Keith Hock
  • Director, Financial Advisory Services
  • (513) 252-0223
  • khock@gbq.com