April 2013

A discounted cash flow (DCF) analysis is a commonly-used and conceptually excellent method of performing a business valuation in which a projection is made of expected future results. However, it is possible to manipulate the inputs into the future projection to arrive at specifically-desired results. Once completed, it is also important to consider how heavily it should be weighted in the overall conclusion of value.  Recent court cases have more frequently underscored the need for appropriate application and consideration of both the income and market approach.

One such case is U.S. Bank National Association vs. Verizon Communications Inc in the US District Court for the Northern District of Texas (Civil Action No. 3:10-CV-1842-G, January 22, 2013).  In this ten-day bench trial, the only issue was the value of a Verizon spinoff (Idearc) on the day of the spinoff. The Court found that plaintiff’s witness “is highly qualified to offer an opinion”, yet rejected her conclusions because she provided (without proper justification) 70% reliance on what the Court described as a biased application of the DCF approach.  This resulted in an unusually low indication of value given the other information available. The Court summarized her approach as follows (citations omitted throughout):

“Taylor made three separate calculations of Idearc’s value on the date of the spinoff, one based on discounted cash flow (the “DCF method”), a second based on EBITDA multiples of a select group of public companies ostensibly similar to Idearc (the “market multiple method”), and a third based on EBITDA multiples implied by transactions involving public companies ostensibly similar to Idearc (the “comparable transaction method”). Using the DCF method, Taylor arrived at a value for Idearc ranging from $5.4 to $6.3 billion. Using the market multiple method, Taylor arrived at a value ranging from $11.7 to $13.2 billion. Using the comparable transaction method, Taylor arrived at a value ranging from $13.4 to $15.8 billion. By weighting the DCF method calculation at 70%, the market multiple method calculation at 15%, and the comparable transaction method calculation at 15%, Taylor ultimately arrived at a value for Idearc that ranged from $7.5 to $8.8 billion. The midpoint of that range is $8.15 billion, which Taylor concluded was the value of Idearc on November 17, 2006, the date of its spinoff from Verizon.”

The heavy reliance on the “outlier” valuation of Idearc under the DCF method was rejected by the Court, who was not impressed with the witness’ approach and conclusions. The Court summarized its criticisms as follows:

“At nearly every step in the DCF analysis, Taylor selected inputs that forced Idearc’s value lower. From her selection of only the most pessimistic projections of Idearc’s future performance, to her reliance on a “commercially unreasonable” terminal value projection and calculation, to her selection of a remarkably high discount rate, the method produced a valuation that is low in the extreme and that implied an incredibly low trading multiple for Idearc.”

In performing her analysis, the expert also completely eliminated from consideration the value of Idearc based on trading on the NYSE on the date of the spinoff.  This $12.8 billion total enterprise value of Idearc was within the range of the expert’s other market-based indicators.  The unusual nature of a decision to ignore this data point was acknowledged by the expert, who testified that “it would be customary for a valuation professional to consider the price of a company’s stock publicly traded on an efficient market as a prime indicator of its value” and that “this was the first time she had ever opined that the market price of stock was completely unreliable as to a firm’s value”. Her justification for her exclusion of this data point was that she believed material information was kept from the market:

“As part of her analysis of value, Taylor did not consider the trading price of Idearc on the NYSE on the date of the spinoff. She testified that, in her opinion, investors overvalued Idearc because of various alleged misrepresentations and omissions made by Verizon (conceding that her opinion “turn

[s]” on the proposition that “the market was misled” into inflating Idearc’s equity value by at least $4 billion). First, Taylor concluded that Verizon failed to disclose the significant differences in the EBITDA margins generated by VIS’s incumbent print and electronic businesses. Second, she also concluded that Verizon concealed the year-over-year declines in revenue in specific northeastern urban markets.. Third, Taylor opined that the fact that management had consistently failed to meet its projections, but hadn’t disclosed these missed projections to the market, rendered Idearc’s stock price unreliable. Fourth, Taylor opined that the fact that Verizon did not disclose a pessimistic report by the consulting firm McKinsey about the directories business’s future prospects rendered Idearc’s stock price unreliable”

In summary the expert concluded the following indicators of value and respective weightings:

DCF $5.4 to $6.3 billion 70%
Market Multiple $11.7 to $13.2 billion 15%
Comparable Transaction $13.4 to $15.8 billion 15%
Actual Trading Price $12.8 billion 0%
Value Conclusion $8.15 billion

 

The Court instead found that the total enterprise value of Idearc on November 17, 2006 was at least $12 billion.

Data supporting each appraisal is different, and so customized decisions are needed for each assignment. But this example warns parties not to embrace an “outlier” because it provides a desired result, as plaintiffs attempted to do here.

 

Fulcrum Inquiry performs valuation and appraisal services.