As business valuation professionals, we are put into a position of incredible responsibility. When buyers and sellers agree to transact, the valuation firm, whether an investment bank or consulting firm, must provide the correct value within a very narrow margin of error. Although financial theory is considered a science and the cornerstone of business valuation, the selected methodologies and many assumptions are decisions of the valuation practitioner. These decisions can make or break a business valuation and create the perception of valuation as part “art” as well as science. In reality, a thorough and logical valuation process, which includes comprehensive due diligence, market research, and independent review, can go a long way to supporting logical judgement and ultimately result in the most defensible business valuation.
Several Delaware Chancery Court matters highlight perfect examples of the business valuation process gone wrong. These include the shareholder derivative action of Southern Peru Copper (“Southern”), wherein a decision was rendered by Chancellor Leo E. Strine Jr. in October 2011, and the breach of fiduciary duty case against certain executives of Dole Food (“Dole”), decided by Vice Chancellor J. Travis Laster in August 2015. The Southern case ultimately resulted in $1.26 billion in damages awarded to the plaintiffs. The Dole case resulted in $148 million in damages, for which Dole’s CEO and president/COO were personally liable.
The Southern case is interesting given its sheer size. In 2004, Southern was a NYSE publicly traded company with substantial mining, smelting, and refining operations in Peru and a market capitalization of approximately $3.4 billion. Grupo Mexico (“Grupo”), traded on the Mexican stock exchange, owned 99% of Minera, which was engaged in coppering mining in Mexico and in 2004 was experiencing financial difficulties. Grupo owned approximately 54% of Southern’s shares and approximately 63% of its voting power. The chairman and CEO of Grupo was also the chairman and CEO of Southern.
In 2004, Grupo, seeking liquidity and to combine its Mexican and Peruvian mining operations, offered to sell Minera to Southern in exchange for $3.1 billion of newly issued Southern shares. Given the conflicts, a special committee of the board of Southern was formed to evaluate the transaction on behalf of Southern’s shareholders. In October 2004, the special committee approved the transaction in which Grupo would receive $3.1 billion worth of Southern’s shares in exchange for Minera. By the time the transaction closed in early 2005, the value of such shares had risen to $3.8 billion. Subsequently, a derivative lawsuit was filed against the Grupo-affiliated directors of Southern and members of the special committee, alleging the transaction was unfair to Southern and its minority shareholders. The core problem was that Grupo paid $3.1 billion worth of newly issued shares in Southern for an asset (Minera) that the special committee and its financial advisor valued at much less.
Several interesting points surfaced in the case. In order to justify the exchange rate on the transaction, the special committee and its financial advisor focused on valuing both Southern and Minera on a relative basis using intrinsic value (i.e., based on a fundamental valuation and not the publicly traded share price) despite the fact that Southern was a large, publicly traded company with a market capitalization in excess of $3.0 billion. Such an analysis resulted in a value for Southern of approximately $2.1 billion, or roughly two-thirds of its June 2014 market capitalization.
Regarding Minera, the special committee and its financial advisor used various valuation methods, including discounted cash flow analyses, multiples from similar publicly traded companies, and a sum-of-the-parts analysis of Grupo, all of which produced a value of Minera in the range of $227 million to $1.7 billion using midrange assumptions, well shy of $3.1 billion. According to the decision, even the most aggressive valuation assumptions yielded a value for Minera of $2.8 billion. Ultimately, the court determined the defendants breached their fiduciary duty by paying $3.1 billion for an asset that was worth substantially less than that figure. In addition, the court criticized the narrow mandate of the special committee to only evaluate the transaction (as opposed to considering alternatives to it), and the fact that the special committee failed to change its recommendation (from being in favor of the transaction to not being in favor) despite the substantial increase in value of the consideration at the time of transaction close in early 2005. In deciding damages, Chancellor Strine used his own valuation, based on a discounted cash flow analysis and multiples of publicly traded companies as well as values of Minera implied in early negotiations, to appraise Minera at $2.4 billion.
Looking at the valuation aspects of the Southern case, the decision to value Southern based on a fundamental valuation at well below its market capitalization was obviously critical to the special committee’s decision to recommend the transaction to the shareholders, and to the financial advisor’s fairness opinion. By establishing a value on Southern at below the then-current trading price of the stock, it helped justify the higher exchange ratio for Minera. Such an approach was considered a flaw in the valuation process. Most valuation analyses and fairness opinions include a fundamental valuation based not only on the company’s share price, but also analysis of an Income Approach (discounted cash flow analysis) and a Market Approach (multiples of similar publicly traded companies and representative mergers and acquisitions). In determining whether a public company’s share price is a reasonable indication of fair value, analysts will look at several factors: the trading exchange on which a company’s shares are traded (the NYSE being perhaps the most liquid exchange); the subject company’s float, institutional ownership, share price and analyst coverage; and the stock’s reaction to news. Large companies, with heavily traded stocks, that have substantial analyst coverage, and that react to news are generally considered to have stock prices more indicative of fair value relative to thinly traded small- or micro-cap stocks. The other key flaw was the valuation of Minera. With regard to Minera, midrange projection assumptions produced a value of at the high end of $1.7 billion, again well shy of the $3.1 billion transaction price.
The Dole case is interesting given that it was a going-private transaction in late 2013. Dole’s CEO, who owned 40% of the stock, acquired the publicly traded shares for $13.50 per share – a 20% premium to the original asking price of $12.00 per share. The transaction price of $13.50 per share was negotiated and approved by an independent special committee of the board. The plaintiffs in the case contended that Dole’s CEO and president/COO breached their fiduciary duties and committed fraud by manipulating information released to the public and canceling a stock-repurchase program, both of which depressed the share price prior to the CEO negotiating the deal. Although a special committee of the board was formed to evaluate and negotiate the transaction, the court found that the CEO restricted the special committee’s mandate to specifically consider the CEO’s proposal and for no other purpose such as exploring superior alternative transactions. The court further found that the projections provided to the special committee and Dole’s financial advisor by the president/COO were inconsistent and much lower relative to projections given to Dole’s banks and discussed as part of Dole’s recent divestiture of its Asia business operations. Furthermore, according to the court, the CEO reduced cost-savings estimates stemming from the previous divestiture, which caused Dole’s stock price to drop prior to the CEO’s proposal to bid on the stock. Ultimately, Dole’s CEO and president/COO were found jointly and severally liable for breaches of fiduciary duty and forced to pay damages of $148 million, or $2.74 per share.
Looking at the valuation elements of the Dole case, Dole’s projections became a pertinent topic. The fact is that companies often prepare several sets of projections. Some projections may have more aggressive assumptions, especially if they are used as management goals, while others may be more conservative, such as for banking purposes. In this case, the projections and cost-savings assumptions given to the bank that was financing the buyout were more optimistic and contradicted information presented to the public and the special committee. Lower projections, on top of a canceled share-repurchase program, ultimately depressed Dole’s share price just prior to the CEO buyout of the company.
A complete valuation process will involve a review of the subject company’s projections to understand whether or not such projections are reasonable for valuation purposes. In addition, the subject company’s experience in making and achieving forecasts will often be analyzed. Rest assured, in most valuation litigation matters, scrutiny of projections becomes a focal point. At trial, the special committee’s financial advisor recognized that the projections were unreliable and tried to overcome the information deficit, but was unable to fully do so in the eyes of the court.
Business valuation is not based on a single algorithm, but instead is a complex process. The quality and reliability of the valuation are based on the thoroughness of the valuation process. Such a process includes gathering and analyzing information, performing due diligence, applying appropriate valuation methodologies, and testing the ultimate results for logic and consistency with the facts.
In the Southern case, the fundamental valuation of Southern was not logically consistent with the company’s market capitalization, yet was a key factor in the ultimate purchase price and fairness opinion. In addition, the projections as well as other elements of the valuation analysis of Minera did not support the $3.1 billion purchase price. In Dole, the market and banks were given inconsistent information versus that provided to the special committee and the public shareholders, which ultimately rendered the purchase price of Dole’s stock questionable. In both cases, flaws in the valuation process proved to be costly for the defendants.