The story so far…
Two experts, bruised by various criticisms, were required to value a company at the time that it had been spun out of a group. Immediately thereafter a power company, SSE, a listed energy company, had paid £6 million for a stake of 30%.
One of the experts expressed uncertainty as to the recoverability of balances due from related companies: if they were recoverable her valuation range was £7 million to £9.4 million. If those balances could not be recovered, the valuations fell considerably to a range from £3.7 million to £6.1 million. The price paid by SSE should be ignored as it represented a special purchaser making a strategic acquisition.
The other expert considered that the price paid by SSE was indicative of market value. His valuation range, using this information, was £18 million to £22 million. This was then reinforced by his conclusions using other valuation methods.
The view from the bench
In my judgment, the SSE acquisition price cannot be dismissed as easily as [the expert] contends. SSE was a substantial and highly experienced operator in the field in which Vital operated. It undertook extensive due diligence. Its conclusion that £6 million was a fair price for 30% of the shares deserves to carry significant weight in seeking to arrive at a value of 100% of the shares.
Discounted cash flow techniques
“a DCF valuation is usually considered to be the best methodology to apply to the valuation of a profitable trading business because it relies on company and market data and analytics in a way that an earnings approach does not.”
This was eschewed by the other expert initially on the unexpected basis of the limitations of her instructions. She then stated that there were no reliable projections as she would normally expect projections to be for periods of from five to ten years.
She criticised the DCF calculations which were carried out as there were no cash flow adjustments after the net operating profit after tax, in respect of differences between depreciation and capital expenditure and changes in working capital. It seems that no allowance had been made for general balance sheet expansion as a result of growth.
She also disagreed with the discount rate used of 14.14%. The discount rate is not fully explained in the written decision but is consistent with the following:
| Risk free rate | 2.5% |
| ERP | 6.0% |
| Beta | 0.94 |
| Private equity premium | 3.0% |
| Company specific risk premium | 3.0% |
| Discount rate | 14.14% |
It was her view that the RFR was too low and the ERP too high. She also questioned the justification for the private equity premium as this was not a private equity transaction.
It appears that these criticisms did succeed to sow the seeds of doubt. The Judge stated:
“I conclude that while [the expert's] DCF valuation is a helpful piece of the picture, there are nevertheless good reasons to apply a not insignificant discount to his figure.”.
PCPI in the spotlight
In some previous cases evidence from indices such as the BDO PCPI has been accepted. In others the opacity of such indices has been their downfall. In this case a 2007 valuation undertaken by the auditors was criticised on the basis that the p/e ratio stated was very much below the PCPI index.
The PCPI Index was also referred to as a source for a discount of 35% for application to the p/e ratio of listed public companies in order to derive the p/e ratio for a private company.
The Judge found that the auditors’ valuation was not of assistance as contemporaneous evidence as they had undervalued the company. Rather unexpectedly one of the experts had based the assessment of multiples by reference to the auditors’ valuation. The ramifications were therefore rather greater than might have been the case.
Maintainable profits and multiple
It appears that the valuations were direct equity valuations, rather than via enterprise value. The doubt relates to the use of net operating profits after tax as the proxy for cash flows in the DCF calculations.
Rather unusually one of the experts abandoned her own estimate of earnings of £2.4 million and accepted the figure of the other expert subject to a reduction for finance costs. This resulted in agreed earnings of £1.029 million. This had the impact that her assessment of the SSE offer meant that the implied multiples more than doubled.
The Judge determined that a p/e ratio of 14.6 was appropriate for the value of Vital, with a valuation for the entire equity of £15 million. This represented a discount of 25% from the price per share paid by SSE and a discount of 35% from the DCF-based valuation.