How Not to Use Duff & Phelps Data
A Discussion of Rover Pipeline, LLC v. 10.55 Acres of Land, More or Less, in Ashland County, Ohio, et al.
“In God we trust. All others must bring data.” This famous saying has been attributed to various people, but it implies that when data is presented, the conclusion can be trusted. However, the Ohio District Court’s decision in Rover Pipeline, LLC v. 10.55 Acres of Land, More or Less, in Ashland County, Ohio, et al., demonstrates that data is only trustworthy if it is understood and applied correctly. The case, in which the expert’s valuation report was discarded due in large part to the misuse of data, demonstrates the risk of misapplication of data in valuation reports and highlights how the misuse of data can prevent an accurate assessment of value. You can read the full article in the May/June 2019 issue of The Value Examiner.
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“In God we trust. All others must bring data.” This famous saying has been attributed to various people, but it implies that when data is presented, the conclusion can be trusted. However, the Ohio District Court’s decision in Rover Pipeline, LLC v. 10.55 Acres of Land, More or Less, in Ashland County, Ohio, et al.,[1] demonstrates that data is only trustworthy if it is understood and applied correctly. The case, in which the expert’s valuation report was discarded due in large part to the misuse of data, demonstrates the risk of misapplication of data in valuation reports and highlights how the misuse of data can prevent an accurate assessment of value. You can read the full article in the May/June 2019 issue of The Value Examiner.
Case Background
In early February 2017, Rover Pipeline, LLC (Rover) filed a civil action pursuing condemnation of approximately 700 tracks of land in the northern district of Ohio through which it intended to construct a pipeline. Rover was previously authorized by the Federal Energy Regulatory Commission to construct and maintain an interstate natural gas pipeline system traversing through West Virginia, Ohio, Pennsylvania, and Michigan. The Company had reached settlements with the majority of affected property owners along the route of the proposed pipeline as well as all defendants on the matter of “immediate possession.” However, it was unable to reach agreements with a few of the property owners on the issue of “just compensation” and turned to the courts to resolve the issue.
Pine Tree Holding Inc. (“Pine Tree”) was founded in 2004 and is a tree farm company located on a tract of land totaling over 100 acres in Wayne County, Ohio. The company is organized as an S corporation with landowners Roger and Rita Dush owning 100 percent of its stock. Pine Tree primarily serves residents and tree suppliers with annual Christmas trees and is known for its Fraser Fir trees, which are grown in only limited areas in the state. Rover was granted temporary and permanent easements on approximately 7.5 acres of the Dush’s land for the construction of its pipeline. However, Rover and the Dushs were unable to agree on just compensation for the land.
Both parties engaged expert witnesses on topics related to the case, including soil, horticulture, real estate, and economics to determine just compensation, and both parties challenged the admissibility of the opposing expert opinions.
Valuation and Analysis
One of the landowners’ experts was tasked with determining the value of the Christmas tree business and did so using three methodologies: the Asset Approach, the Income Approach, and the Market Approach. The Asset and Market Approach analyses indicated losses to the landowners of $167,000 and $157,000, respectively. Based on the Income Approach, however, the landowners’ expert concluded that the loss to the landowners was $888,000.
While several issues surrounding the valuation methodology were disputed in the matter, for purposes of this article we focus on the incorrect use of Duff & Phelps data in the expert’s analysis and the Court’s criticism of that analysis.
- Risk-Free Rate and Equity Risk Premium
The Court questioned the expert’s use of Duff & Phelps’ guidelines for the risk-free rate and equity risk premium citing that the expert “admitted they are reserved for much larger companies worth between $2.3 and $5.6 billion.”[2] However, Duff & Phelps’ risk-free rate and equity risk premium guidelines are used to calculate the cost of capital for all companies, regardless of size.
The expert applied the normalized risk-free rate and Duff & Phelps recommended equity-risk premium, the spot rate, and supply-side equity risk premium have been used frequently in Delaware Chancery Court.
- Size Premium
The expert incorporates a size premium of one percent based on the company’s “stable history and lack of debt” rather than using an authoritative guide to determine a size premium. In fact, Duff & Phelps (who the expert relied on for the risk-free rate and equity risk premium) also publishes two sources to determine a size premium:
- The Center for Research in Securities Prices (CRSP) Deciles Size Premia Study
- The Risk Premium Report Study.[3]
For comparison purposes, had the expert used the 10th decile in the CRSP Deciles Size Premium Study Exhibit to determine the size premium, she would have used premiums of 5.60 percent and 5.59 percent rather than one percent for the December 31, 2016, and June 14, 2017 valuations, respectively.
The expert testified that she relied on unsubstantiated information presented at a continuing education class for the one percent figure rather than an authoritative guide. In fact, contrary to the expert’s testimony regarding the reason why she chose one percent, the company’s “stable history and lack of debt” are irrelevant to the size premium. Both the opposing expert and the Court criticized the expert’s use of the one percent size premium rather than Duff & Phelps’ 5.59 percent figure. The Court noted that the expert “did not explain why she used the ‘generally accepted’ Duff & Phelps numbers when they raised her valuation but ignored the guide’s suggested number when it lowered her valuation.”[4]
Note: While the 5.59 percent guideline in the 2017 Valuation Handbook was publicly available as of June 14, 2017, it was not available as of December 31, 2016. The correct size premium to use in the December 31, 2016 valuation is 5.60 percent, which is provided in the 2016 Valuation Handbook and which was publicly available as of the December 31, 2016 valuation date. While contemporaneous valuations typically will not suffer from these kinds of errors—retrospective valuations performed in Court can often suffer from these kinds of errors. It is important for practitioners to understand when data was made available by Duff & Phelps.
- Company-Specific Risk Premium (C-SRP)
The landowners’ expert incorporated a company-specific risk factor into the post pipeline valuation but did not incorporate a company-specific risk factor in the pre-pipeline valuation. The expert applied the two percent company-specific risk premium post-installation to account for any problems associated with the construction and maintenance of the pipeline on the property. However, the expert was not able to identify any literature to support a zero percent pre-installation and two percent post-installation C-SRP.
Historically, the Courts have rejected the use of unsubstantiated company-specific risk premia when offering expert testimony.
Given the unsubstantiated nature of the expert’s C-SRP, the two percent C-SRP should have been avoided.
The impact of the expert’s data errors is significant. When applying the correct size premium and eliminating the company-specific risk premium, damages total $147,604, in line with the Asset and Market Approach valuations.
Decision and Takeaway
The District Court determined that the expert’s approach to the valuation was flawed and as a result, was inadmissible. While several issues were cited, the Court placed significant emphasis on the data used in the Income Approach that rendered it unreliable including:
- The expert’s questionable determination of the capitalization rate,
- The expert’s rejection of the 5.59 percent Duff & Phelps recommended size premium in favor of a one percent unsupported size premium, and
- The application of an unsubstantiated company-specific risk premium of two percent post-pipeline installation. The judge criticized the expert’s use of the data stating, “Given the fact that this decision resulted in a calculation that was several times what the other two valuation methods yielded, [the expert’s] inability to explain or defend her calculation adequately is decidedly troubling.”[5]
The decision in Rover Pipeline LLC v. 10.55 Acres of Land, et al., firmly demonstrates that the ability to defend data is essential to its credibility. The judge’s message to valuation professionals is clear: understand, correctly apply, and substantiate data to form reliable conclusions admissible in the courtroom.
[1] Rover Pipeline, LLC v. 10.55 Acres of Land, More or Less, in Ashland County, Ohio, et al., United States District Court, Northern District of Ohio, Eastern Division, Case No. 5:17-cv-239 (September 14, 2018).
[2] Memorandum Opinion p. 20, footnote 10.
[3] Both of these size studies are now available through the on-line Cost of Capital Navigator; see dpcostofcapital.com
[4] Memorandum Opinion p. 20.
[5] Memorandum Opinion p. 21.
Roger J. Grabowski, FASA, is a Managing Director with Duff & Phelps, LLC. and an Accredited Senior Appraiser and Fellow (FASA) of the American Society of Appraisers (ASA) (their highest designation), Business Valuation. He is a co-author with Shannon Pratt of Cost of Capital: Applications and Examples, 5th ed. (John Wiley & Sons, 2014); The Lawyer’s Guide to Cost of Capital (ABA, 2014); and Cost of Capital in Litigation: Applications and Examples (John Wiley & Sons, 2010). He is a co-author of the Duff & Phelps annual resources for cost of capital data: on-line Cost of Capital Navigator; Valuation Handbook – Industry Cost of Capital; International Valuation Handbook – Guide to Cost of Capital; and International Valuation Handbook – Industry Cost of Capital (Duff & Phelps).
Mr. Grabowski can be contacted at (312) 697-4600 or by e-mail to Roger.Grabowski@duffandphelps.com.
Jaime d’Almeida, ASA, CFE, is an Expert Affiliate with Duff & Phelps, LLC. He has over twenty years of experience in economic and valuation analysis and consulting, and has provided both deposition and trial testimony on valuation, finance, and damages issues. He is a Lecturer in Finance at Boston University’s Questrom School of Business, and an Adjunct Lecturer at Babson College’s F.W. Olin Graduate School of Business.
Mr. d’Almeida can be contacted at (617) 378-9445 or by e-mail to Jaime.Dalmeida@duffandphelps.com.
Debra Jacobs is a Vice President with Duff & Phelps, LLC. She has over fifteen years of experience providing financial, economic, and valuation analyses for a broad range of industries. Ms. Jacobs has performed business and securities valuations as well as financial analysis for litigation, arbitration, financial advisory, and tax purposes.
