Abstract:   This article discusses a key issue in defensible business valuations: diversity of approach. A recent Tax Court case arose when a shareholder filed suit after a company announced a recapitalization agreement. The allegation was that the agreement significantly undervalued the company and therefore improperly transferred wealth and voting power from its minority shareholders to its primary debt holder. The plaintiff’s expert arrived at an exceptionally high value using only the discounted cash flow method. But the court rejected this approach, placing greater credence on the defense’s use of multiple valuation techniques.

Power of three

Court endorses triangular valuation approach

What makes for a defensible business valuation? Well, many things — but one key element is a diversity of approach. That is, if an appraiser uses several different methods to estimate value, his or her valuation will be more likely to hold up in court.

Although a few years old at this point, the Delaware Chancery Court’s 2011 decision in S. Muoio & Co., LLC v. Hallmark Entertainment Investments still provides a great example of the importance of multiple approaches. Here the court urged the use of a more robust type of business valuation that applies multiple techniques to “triangulate” a value range.

Dispute at hand

The case involved the recapitalization of Crown Media Holdings, Inc. by its controlling stockholder and primary debt holder, Hallmark. When the recapitalization was first proposed, Crown’s cash flows were insufficient to service its debt. After the recapitalization agreement was announced, a shareholder, Muoio, filed suit to stop it. The suit alleged that the agreement significantly undervalued Crown and therefore improperly transferred wealth and voting power from Crown’s minority shareholders to Hallmark.

At trial, Muoio’s expert relied solely on a discounted cash flow (DCF) analysis to calculate his $2.9 billion valuation of Crown — almost three times higher than any of the other valuations presented by Hallmark’s experts and advisors. Although Muoio’s expert conducted two other valuations, a comparable companies analysis (which produced a value of $803 million) and a comparable transactions analysis ($1.3 billion), the expert rejected those conclusions as “absurdly low” in comparison to his DCF analysis.

Wildly divergent results

In its opinion, the court included a chart to visually demonstrate “just how far off

[the plaintiff’s expert’s] single methodology valuation was as compared to the multiple valuations of Crown,” which were performed by financial advisors engaged for the transaction and others that had previously considered acquiring Crown. The court also noted that the plaintiff’s valuation was “wildly divergent” from other valuations that had used multiple methodologies.

The court went on to credit the defense expert for recognizing the economic reality that real-world valuations conducted by potential buyers are often the best source of information about a company’s value. It agreed with the defense expert that a DCF analysis is more reliable when it can be verified by alternative valuation methods — especially valuations performed by potential third-party buyers. According to the court, the plaintiff’s expert’s failure to incorporate other methods in his analysis made his valuation far less credible.

Getting specific

The Chancery Court also listed several specific reasons for rejecting the plaintiff’s expert’s value. These include the facts that:

  • The expert’s DCF analysis ignored Crown management’s contemporaneous projections and used his own hypothetical and overly optimistic set of projections.
  • He unreasonably extended his optimistic projections to 2024, despite the fact that management considered it problematic to project more than five years and consistently used three- to five-year forecast periods.
  • His valuation disregarded all of the contemporaneous evidence of Crown’s value (including at least 18 valuations that were nowhere close to his own) and the company’s economic reality (including its debt load).
  • He rejected his own market-based valuations “because he was not satisfied with the results.”

The court ultimately found that, because the expert failed to clearly and persuasively provide any acceptable reasons for his outlier result, his methodology left it with little confidence in his valuation.

Death of DCF?

Did the Muoio court’s decision signal the end of the DCF method? Hardly. It remains a valid valuation approach today. Indeed, as the court observed, a DCF valuation is a dependable and commonly used methodology that merits the greatest confidence in the financial community.

But the court also emphasized that it gives more credit and weight to the opinions of experts who apply multiple valuation techniques that can cross-check and reinforce one another’s conclusions. Other courts would likely agree — both then and now.