In response to our coverage of In re Orchard Enterprises, Ted Israel (Eckhoff Accountancy) finds much to compliment in the Chancery Court’s opinion, but also two major points to criticize regarding the court's characterization of the build-up method as: 1) lying outside “mainstream” financial theory; and 2) being a variation of the Duff & Phelps “model” for deriving the cost of capital.
In dicta, the court says it cannot find any corporate finance texts that discuss the BUM, but “I cannot think of any recent BV books that fail to mention it,” Israel says, citing works by Hitchner, Trugman, Practitioners Publishing, and, “perhaps most significantly,” Ibbotson’s SBBI Valuation Yearbook and Pratt and Grabowski’s Cost of Capital, both of which devote entire chapters to the build-up method and are also cited by the court for different propositions. “The build-up method is certainly part of the ‘mainstream’ body of knowledge for valuing private companies,” Israel says, “and is indeed a widely recognized and important tool for developing cost of capital estimates.”
The Delaware court also disparages the BUM for involving a great deal of subjectivity when, in fact, the company-specific risk premium is its “only subjective component,” Israel points out. The remaining inputs—such as the risk-free rate, the ERP, the size premium, and the industry risk premium (or beta)— “are all provided by empirical sources such as Ibbotson and Duff & Phelps.”
As for the CSRP, the court was “absolutely correct” in saying it warrants close scrutiny, Israel says, but it failed to grasp the principle behind its use in private company valuations, i.e., to estimate the risk that data from public companies do not include, largely due to their investors’ ability to diversify. (Pete Butler from Valtrend also picked up on this disconnect, noting the court cited Damodaran on Valuation as one example of the CSRP failing to find support among finance scholars. “However, like all academic textbooks, it is written from the perspective of the public stock investor,” Butler says. “When Prof. Damodaran considers the perspective of a private company investor, he ‘invented’ total beta and/or the ‘private company beta’ to appropriately price for CSR.”)
Finally, both the SBBI and Duff & Phelps Risk Premium Report provide “useful and reliable” data for developing COC estimates using both the CAPM and build-up models, Israel says. However, an “uninformed reading” of the Delaware Chancery’s decision “could cause an analyst to avoid the D&P data, and that would be a disservice.” The complete digest of the decision will appear in the October Business Valuation Update; the court’s opinion is already posted at BVLaw. Look for Israel’s complete commentary on the case in the November issue.