Supply-side ERP more reliable, says Delaware Chancery

BVWireIssue #93-2
June 16, 2010

In the latest “must read” statutory fair value appraisal from the Delaware Chancery Court, the decision (by V.C. Strine) tackles such critical valuation topics as deference to the market price, determination of the terminal growth rate, historic versus supply-side equity risk premium (ERP), and selection of appropriate beta. In a case that was “largely dominated by the testimony of the experts,” the court also found that currency and consistency, plus reliance on peer-accepted methods and data, was critical to the experts’ credibility.

Determination of the ERP was a source of major disagreement between the experts, whose per-share values of the Russian telecom company at stake differed by more than 30%. The company’s expert chose 7.1%, based on the long-term, historical rate in Ibbotson’s 2008 SBBI. In support, he cited materials from Ibbotson’s as well as two articles from the Business Valuation Update™; (Peng Chen, James Harrington, “Ibbotson Authors Discuss Historical and Supply-Side Estimates of ERP,” Jan. 2008; and James Hitchner, Katherine Morris, “Cost of Capital Controversies: It’s Time to Look Behind the Curtain,” Jan. 2005, both available at BVResources.)

Critically, all the cited materials discussed supply-side ERP as well. Accordingly, the petitioners’ expert chose the supply-side ERP of 6% reported in Ibbotson’s 2007 Yearbook, which says “the historic approach wrongly assumes that the relationship between stocks and bonds observed in the past would remain stable into the future,” and over the long run, “the equity return should be close to the long-run supply estimate.” This selection had “substantial support in the professional and academic valuation literature,” the court held, in adopting the 6% ERP. “Shannon Pratt, for example, has urged his readers who still use an ERP of 7% to ‘immediately make a downward adjustment to reflect recent research results,’ and has written that the ‘ERP as of the beginning of 2007 should be in the range of 3.5% to 6%,’” the court said, (citing Pratt and Roger Grabowski, Cost of Capital: Applications and Examples, 3rd ed. 2008, also available at BVResources).

Read the complete digest of Global CT LP v Golden Telecom, Inc., 2010 WL 1663987 (Del. Ch.)(April 23, 2010) in the next (July 2010) BVUpdate; the court’s opinion will be available soon at BVLaw™.

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