August 20th, 2013 by Rebekah Smith
In our February newsletter, I wrote about a U.S. Bankruptcy Court’s recent suggestion that the “striking” disparity between experts’ conclusions in a case before it, “lends credibility to the concept that the DCF method is subject to manipulation.” This post summarizes another case from the Delaware Chancery Court that addresses the same issues.
Coming from both cases are almost eerily similar opinions with respect to the expert’s “selecting parameters that pushed his valuation in the direction he wanted to go” (from the Bachrach case) and from this Verizon case, “for nearly every step of the DCF analysis, [the plaintiff’s expert] selected inputs that forced [the company’s] value lower.” These aren’t the only two cases where the Courts have been critical of valuation experts and over the next few blog posts; we will recap those cases here, as well. Stay tuned!
U.S. Bank B.A. v Verizon Communications, Inc.
The issue in U.S. Bank B.A. v Verizon Communications, Inc. (2013 U.S. Dist LEXI 8521) was the enterprise value of a Verizon wholly owned subsidiary on the day that Verizon spun it off as an independent company that subsequently filed Chapter 11 bankruptcy in early 2009. There were contemporaneous valuations which indicated the enterprise value ranged between $10.5 and $15 billion.
The Plaintiff employed an expert for the litigation who employed three methods: the “market multiple method”, the “comparable transaction method”, and the Discounted Cash Flows Method (“DCF”). The first two methods produced a range of value from $11.7 billion to $15.8 billion. The DCF however, resulted in a valuation range of $5.4 billion to $6.3 billion. The Plaintiff’s expert weighted the DCF method at 70% and the other two methods at 15% each resulting in a value range of $7.5 billion to $8.8 billion and concluded that the business was insolvent at the time of the spin-off when considering the spin-off debt.
The Defendant’s expert offered criticisms of the Plaintiff’s expert’s DCF calculation. Among those were that the expert: used overly pessimistic and inappropriate projections, made an inappropriate downward adjustments to an already conservative projection of the cash flows, made assumptions that were not based in reality, employed an inflated discount rate, and used a capital structure that was not consistent with the industry in the US. Further, the DCF approach resulted in an outlier that was inappropriately assigned more weight than the other two, more consistent valuation approaches.
The Defendant’s expert demonstrated that merely correcting for these items led to an increase in the value to a range of $9.7 to $10.6 billion and invalidated the Plaintiff’s expert’s conclusion that the business was insolvent.
The Court found for the defendants’ valuation. “For nearly every step of the DCF analysis, [the plaintiff’s expert] selected inputs that forced [the company’s] value lower,” the Court said. The result was a valuation “that is low in the extreme and that implied an incredibly low trading multiple for [the subject.]” Further the Court concluded that the plaintiff’s DCF method produced a value that — by the expert’s own admission — was an outlier, yet rather than disregard and assign a low value to the “outlier,” the expert did the opposite and assigned it a high weight.