February, 2007 | Issue 15
In a case called In Re PNB Holding Co. Shareholders Litigation, C.A. No. 28-N (Delaware Chan. August 18, 2006), the Delaware Chancery Court showed itself receptive to the use of state-of-the-art financial methodology to value the stock of PNB Holding Company, an Illinois bank holding company.
The shareholders were in court because they were unhappy with the price they had received in a reorganization of PNB. The Bank wished to convert itself to a subchapter S corporation. In order to do so it needed to reduce the number of its shareholders. It did this by carrying out a reorganization under which all shareholders holding fewer than 2,000 shares were required to exchange their shares for $41 in cash per share.
A number of the shareholders felt that this price was too low, and the matter ended up as a combined appraisal/equitable action in Delaware Chancery Court.
The valuation experts for both sides used the same three methods to value the PNB stock; 1) the comparable publicly-traded company approach, 2) the comparable acquisition method, and 3) a discounted cash flow analysis. Although the methods used by both appraisers were the same, the results of their labors produced what the Court described as “the depressingly familiar parentheses,” $61 per share for the plaintiffs’ expert and $40 for the defendants’ expert.
After analyzing the appraisers’ work, the Court decided that it could rely on only one technique, the discounted cash flow (DCF) approach. It felt that neither of the market-based approaches were backed up by sufficiently reliable testimonial and record evidence.
In applying the discounted cash flow method, both experts had to first prepare a projection of the Bank’s cash flow in future years. The projections made by both were remarkably close to each other. The difference in their value conclusions arose primarily from the differences in the discount rates they used to discount the cash flows, 11.5% in the case of plaintiffs’ expert and 14% in the case of the defendants’ expert.
Plaintiffs’ Expert’s Views Prevail
The Court found itself more comfortable with the discount rate argument advanced by the plaintiffs’ expert than that of the defendants’ expert. The plaintiffs’ expert relied on a capital asset pricing model (CAPM) employing an equity risk premium of 7% and a beta of 0.5. He checked his result by using a three-factor Fama-French model, which is a variation of the traditional CAPM model. The Fama-French model takes into account the size and book value of the company being appraised as well as the beta of its industry in calculating the rate of return one would expect on an investment in its stock.
The Court took issue only with the use of a beta of 0.5. It substituted a beta of 0.69 and, weighting the CAPM approach approximately equally with the Fama-French method, arrived at a discount rate of 12%. This produced a value for the PNC stock of $52.34 per share, which was the value conclusion adopted by the Court.