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The Importance of Growth Assumptions in Delaware Appraisal Rulings

An important input to many valuations for disputes in the Delaware Court of Chancery is a business’s terminal value; the future value of a business that reflects all the cash flows expected to occur after the period for which management or analysts typically prepare cash flow projections. In this Q&A, the article’s authors explain how the assumptions underlying such calculations affect the valuation results when employing different valuation methodologies.

In valuation disputes, adjudicators critically examine the methods and assumptions used by opposing experts when estimating a business’s future value.

An important input to many valuations for disputes in the Delaware Court of Chancery is a business’s terminal value; the future value of a business that reflects all the cash flows expected to occur after the period for which management or analysts typically prepare cash flow projections. Different methods can be used to calculate the terminal value, which can lead to divergent estimates among experts in these cases.

Analysis Group Managing Principal Michael Cliff and Vice President Joseph Maloney explored this topic in an article published by the American Bar Association’s Business Law Today. In this Q&A, the article’s authors explain how the assumptions underlying such calculations affect the valuation results when employing different valuation methodologies.

Your article points out that the Delaware Court of Chancery has accepted different approaches for calculating terminal values in different valuations. Why is that important for the parties involved in a valuation dispute?

Dr. Cliff: In a typical discounted cash flow (DCF) model, the terminal value accounts for a meaningful portion of the subject company’s value. One popular valuation treatise presents industry examples where the terminal value represents 56% to 125% of firm value. Differences in approach and seemingly small disagreements about the assumptions that valuation experts use as inputs can produce large discrepancies in the experts’ terminal value calculations.

In Ramcell v. Alltell, for example, the Chancery Court noted that the petitioner and the respondent presented “vastly different” valuations, and that “the disparity in the experts’ valuations are attributed to their sharp disagreements over the inputs to the DCF model and how they should be calculated.”

Why is it difficult to calculate terminal values?

Mr. Maloney: Simply put, a terminal valuation calculation depends on several judgments and assumptions, and experts will need to justify their judgments and assumptions so that they hold up to scrutiny. The terminal value typically reflects the value of cash flows estimated to occur after periods for which there are explicit projections from company management or third parties. That means that the valuation expert preparing a DCF model needs to make assumptions about the profile of long-term cash flows, including revenue growth rates, profit margins, tax rates, and reinvestment needs.

A related challenge is that reliably calculating terminal value generally requires the subject business to have reached a “steady state” in its financial performance, where expected growth and profit margins are stable and sustainable, and the fraction of profits that is reinvested is sufficient to support the assumed growth.

But financial projections prepared by company management in the ordinary course of business typically only extend a few years into the future and may be informed more by current conditions or historical performance than by long-run, steady-state conditions. The valuation expert thus must think very carefully about constraints on inputs to the terminal value calculation that are likely to be present in the long term, even if not currently.

Some approaches for calculating terminal value require experts to make explicit assumptions about these inputs, while other approaches reflect these assumptions implicitly. In either case, the court will critically evaluate the assumptions used in deciding which valuation (if either) to accept.

What are the primary differences between the two approaches you write about, the extrapolation method and the convergence method?

Dr. Cliff: The extrapolation approach and the convergence method are two different ways of succinctly forecasting a business’s cash flows in perpetuity and determining their present value. They differ primarily in how the cash flows are projected.

As the name suggests, the extrapolation approach generally involves extrapolating from a finite set of projected cash flows. An expert applying the extrapolation approach will generally assume that cash flows occurring after the forecast period grow at a constant rate forever.

Cash flows equal after-tax profits less investment, so extrapolating in this way assumes that both after-tax profits and investment grow at the same constant rate forever and implicitly assumes that the percentage of after-tax profits that is reinvested—the “investment rate”—is constant forever. When that investment is too low in comparison to the growth in cash flows assumed, this will produce an implausibly high return on investment.

Mr. Maloney: The convergence approach, by contrast, recognizes that extrapolating a constant investment rate from available projections may not always be appropriate. This is especially true when the level of investment in company-provided projections is lower than would be sustainable in the long term.

A valuation expert applying the convergence approach addresses this problem by growing profits, not cash flows, at a constant rate and tying investment to the assumed growth rate so that higher growth requires higher investment. The result is that the business’s return on investment will slowly converge, as the name suggests, to a target rate over time.

In competitive markets, the expert might assume the return on investment converges with the cost of capital, so that extra growth ultimately does not create extra value. In other words, the expert assumes that there will come a time when the cost of incremental investments will exactly offset the returns from those investments.

If an expert applies the convergence approach in such a way that extra growth does not create extra value in the long term, is that the same as assuming zero growth in profits?

Dr. Cliff: No, and this is an important subtlety. The convergence approach explicitly distinguishes between growth and value creation.

When an expert applies the convergence approach in such a way that the return on investment converges to the cost of capital, growth’s effect on value is neutral, but that is not the same as assuming zero growth. This fits intuition: growth should only add value when a business grows into “good” investments, but growing into “bad” investments should reduce value.

Assuming growth has a neutral effect on value may be appropriate in competitive markets where obviously value-creating investment opportunities may be difficult to find. And, absent capital constraints, a firm should have already undertaken all available value-creating projects. In that case, growing faster (or slower) would actually reduce value.

Is projecting investment many years into the future a unique challenge for experts applying the convergence approach?

Mr. Maloney: Projecting any measure of financial performance in perpetuity is challenging, and that is certainly true for projecting a firm’s investment. But this challenge is not unique to the convergence approach. Other techniques for calculating terminal value, like the extrapolation approach, also reflect an assumption about investment over the long term.

The difference is that the assumption about investment is explicit under the convergence approach, whereas it is implicit under the extrapolation approach. Assuming explicit offers some advantages insofar as it facilitates making sure that projected investment is appropriate considering expected long-run economic conditions.

This article was previously published in Analysis Group Forum 2024 and is republished here by permission.

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Michael T. Cliff, PhD, is a financial economist with expertise in a range of topics, including asset valuation, mergers and acquisitions (M&A), tax shelters, stock analysts’ recommendations, IPOs, REITs, derivatives, and hedge funds. He has extensive experience with large financial datasets, sophisticated econometric models, and simulations. In his consulting engagements, Dr. Cliff has addressed damages modeling, class certification, business and asset valuation, analysis of complex financial structures, analysis of solvency and debt covenants, evaluation of investment strategies, and assessment of due diligence practices. Dr. Cliff has also served as an expert on cases involving valuation, damages, and liquidity discounts. Prior to joining Analysis Group, Dr. Cliff was a finance professor for nine years at Purdue University and Virginia Tech, where he taught a variety of courses at the undergraduate, MBA, and PhD levels. His academic research has been published in leading journals such as the Journal of Finance, the Journal of Business, and Financial Management.

Dr. Cliff may be contacted at (202) 530-2010 or by e-mail to mike.cliff@analysisgroup.com.

Joesph Maloney, Vice President at Analysis Group, specializes in the application of economic and financial theory to questions arising in valuation disputes and complex securities and finance assignments. He has served as an expert and conducted economic analyses in support of academic and industry experts in analyzing equities, stock options and derivatives, preferred and hybrid securities, government and agency fixed-income securities, and intangible assets. Mr. Maloney’s assignments have related to business and asset valuation, contested mergers and recapitalization transactions, insider trading allegations, tax shelters, alleged breaches of fiduciary duty, and bankruptcy and insolvency matters. In these engagements, he managed large case teams, designed and performed analyses in support of expert reports, critiqued opposing expert reports, and assisted with preparation for depositions and trial. Prior to joining Analysis Group, Mr. Maloney worked as a research analyst focused on monetary and capital markets issues at the International Monetary Fund. He also worked in investment banking at Robert W. Baird & Co.

Mr. Maloney can be contacted at (202) 530-2586 or by e-mail to joseph.maloney@analysisgroup.com.