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JUNE 19, 2015 5:00 AM

By: Sujeet Indap

Thereareseveralreasonsthatthebetainputinacostofequitycalculationisperilous.

Thebetaitselfmightnotbestatisticallysignificant,say,oriftheRsquaredisnearzero
(recallthatbetais,literally,thecoefficientonaregressionandisusedtocalculatethecost
ofequitypertheCapitalAssetPricingModel.Costofequity=BetaxEquityRiskPremium
+theRiskFreeRate.Thehigherthebeta,thegreaterthesecuritycovarieswiththe
marketreturnandthusthehigherreturnthatequityinvestorswillrequire).

Andthebetawilloftenvarydependingonthelengthofthelookbackperiodorwhetherit
ishistoricalvspredicted.
ButajudgesrecentopinioninDelawarehascomeupwithareasontorejectahistorical
betaforareasonwecannotrecallseeing:thestockwastoothinlytradedforaperiodof
time.

Thecourtcaseinquestionrelatestothe2011acquisitionofRuralMetro,apubliclytraded
ambulanceprovider,byprivateequityfirmWarburgPincusfor$438m,excludingnet
debt.

ThedirectorsofRuralMetroweresuedbyitsshareholdersforbreachingtheirfiduciary
dutiesinthesaleprocess.Andseparately,RuralMetrosbankersweresuedforaidingand
abettingthedirectorsinsellingthecompanytoocheaplyinordertosecureotherlucrative
financingassignments.

Thedirectorsandoneinvestmentbank,Moelis,settledbeforeatrial.Butanotherbank,
RoyalBankofCanada,contestedthechargesincourtandwindeduplosing(http://www.
morrisjames.com/newsroomarticles328.html).

Toquantifydamagestoshareholders,theDelawarejudgereliedonadiscountedcashflow
analysistofigureoutthehowmuchRuralMetrowastheoreticallyworthinorderto
contrastwiththedealprice($17.25pershareincash).TheDCFrequiredprojectionsanda
costofcapital.Andthecomponentsofthecostofcapitalareariskfreerate,abeta,andan
equityriskpremiumtocalculateacostofequityaswellasacostofdebt.
Hereistheheartofthebetadispute(separatefromotherdisagreementsaboutDCF
methodologyandifRBCsappealoftheaidingandabettingfindingonlegalgrounds).

FromtheoriginalMarch2014decision(http://blogs.reuters.com/alisonfrankel/files/201
4/03/inrerurallasteropinion.pdf)findingRBCliable:

Theparties,however,disagreedonbeta.DagesusedRuralsobservedbetaof
1.2,derivedfromBloombergweeklydatameasuredagainsttheS&P500
fortwoyears.Lysusedmonthlymeasurementsandafiveyearlookback
period.Intheabstract,bothareacceptablemethods.SeeAndaloro,2005WL
2045640,at*15&n.61.Inthisspecificcase,bothmeasuresareproblematicbecause
thereliabilityofanobservedbetadependsonanefficienttradingmarket.Fora
companylikeRuralthatistradedonamajorexchange,[t]urnover
measuredbyaverageweeklytradingof...1%wouldjustifyasubstantial
presumptionofmarketefficiency.5Brombergetal.,Bromberg&Lowenfelson
SecuritiesFraud7:484(2ded.2003).Ruralsstockdidnotstartmeetingthat
benchmarkonareasonablyconsistentbasisuntilthesecondweekof
September2009.ThepartieswillrecalculatebetausingDagessmethodologyanda
measuringperiodfromSeptember11,2009,toMarch25,2011.

FromRBCsappealdatedMay19thofthisyear:

Thetrialcourterredbecausethereshouldbeapresumption...thatcertain
marketsaredevelopedandefficientforvirtuallyallthesecuritiestraded
there,includingNASDAQ,whereRuralsharesweretraded.20Failingtocompute
betaconsistentwithindustrypracticesharplyincreasedtheDCFvalue.ForRural,
evensmallchangestothebetausedinthecalculationsyieldsverylarge
differencesinvalue:usingafiveyearlookbackwithmonthlymeasuresgenerates
abetaof1.454,whichwouldyieldavalueof$16.91pershareusingthetrialcourts
otherinputs.(SeeA2897.)
Instead,thetrialcourtadoptedPlaintiffsproposedbeta,whichyieldedavalueof
$21.42pershare.Inotherwords,thischangeinbetaresultedinaswingin
valueintheDCFofover$100million.Anditisonlybyexclusivelyusingthe
methodologyadvocatedbyPlaintiffsexpertthatPlaintiffwasabletogenerate
outsizeddamages.Moreimportantly,thesensitivityofthesetwofactors(i.e.,thebeta
andgrowthprojections)intheDCFanalysishighlightsthetrialcourtserrorin
 ignoringtheresultsoftheauction(andthesubsequentbankruptcy).Itisunfairto
RBCandsendsthewrongmessagetothemarketsforaDelawarecourttoconducta
valuationwithoutreferencetoactualmarketforces(e.g.,anauctionandabankruptcy)
thatareeasilyobservable.Thisisparticularlytruewhere,ashere,thevaluationis
conductedbyasingleacademicwithnoindustryexpertiseandgenerates
tensofmillionsofdollarsindamagesbychangingasingleinput.

AndsobothRBCandthesuingplaintiffshadduelingbetasdespitesimilarmethodologies.
And,asisexpected,thebetastheyrespectivelyselectedwerebeneficialtotheirsides.
RBCsexpertcameupwithabetaof1.454whiletheplaintiffsexpertcameupwith1.199.
Thelowerthebeta,thelowerthecostofequity,thelowerthecostofcapitalandthehigher
thetheoreticalvalueofRural/Metro.ThehighertheDCFvalueofRural/Metro,the
greaterthedamagesowedtotheplaintiffs.

Inourprofessionalexperience,weveneverbeenaskedtousebetathathadtobeverified
formarketefficiency.Butthebroaderpointisthattherearesomanyacceptablewaysto
calculatebeta,eachofwhichcanleadtofardifferentvaluationresults.Inthiscase,
plaintiffanddefendantusedhistoricalbetabutuseddifferentlookbackperiods(twoyears
vsfiveyears)andfrequencyofobservations(monthsvsweeks).

Bloomberg(seethescatterandregressionabove)hasanobservedbetaandanadjusted
beta.Theadjustmentreflectsaweightedaveragebetweentheobservedbetaand1with
theideathatovertime,allstockswillreverttothemarketbetaof1.

Anothercommonapproachistoavoidthenoiseofanysinglecompanysobservedbeta.
Rathertheapproachistousethemedianormeanunleveredbetaofacompanysindustry
peersandthenappropriatelyleverthatoneforthecapitalstructureofthecompanyin
question.

Still,somedontliketheideaofusingahistoricalfigureforaforwardcalculation.Thedata
analyticscompanyBarrapublishesandsellsaforwardbetabasedonaproprietary
formulacomprisedof13attributes.
However,Delawarehasfrowneduponthepredictedbeta.Hereisanopinionsummary(htt
p://www.stblaw.com/docs/defaultsource/coldfusionexistingcontent/publications/pub
1006.pdf?sfvrsn=2)fromlawfirmSimpsonThacherdescribinghowthecourtjudged
predictedbetaina2010appraisalcase,GlobalGTlpv.GoldenTelecom.
 Forpurposesofestablishingthediscountrate,Strineselectedabetathatgave
2/3weighttotheBloomberghistoricrawbetaforthetargetcompanyand
1/3weighttotherelevantindustrysbeta.TheViceChancellorfullyaccepted
neitherthecompanyexpertsproposedrelianceonhistoricalbetaalonenorthe
shareholderexpertsproposedrelianceonthesocalledpredictivebetafromthe
financialconsultancyMSCIBarra.Strinecraftedhisbalancebetweenhistoricand
industrybetatoaccountforthefactthatthetargetcompanyoperatesinariskier,
emerginghighgrowthmarket.Yet,hetemperedthenumbertoaccountforevidence
thatRussiaisnormalizingandthatthetargetisastablecompanythatcould
eventuallyachieveabetaclosertoitsmoremature,NASDAQtradedpeers.Although
thecourtpredominantlyrelieduponhistoricbetainGlobal,Strine
reservedjudgmentontheuseofthemorepredictiveBarrabetatechnique
infuturecases.Strinenotedthat,unlikethesupplysideERP,theBarra
betasreliabilityisnotpresentlysupportedbytheweightofanyreliable
professionaloracademicliterature.Heindicatedamoredetailedand
objectiverecordofhowtheBarrabetaworksandwhyitissuperiorto
otherbetaswouldberequiredforthecourttoacceptitsapplication.

ThemindblowingpartofaDCFexerciseisthatwithsomanyinputsopentosomuch
appreciation,thecourtpicksthesingleDCFvaluefigureasthecompanyvaluetoassign
damages.Bankerswillpresentacompanysboardtheclassicfootballfieldwithaseries
ofvaluationtechniques(e.g.comps,DCF,LBO)fromwhichtotriangulateavaluation
becauseanysingletechniqueoffersalevelofprecisionthatdoesnotexist.

Thecourt,insomesense,knowsthisrisk,asitironicallyenoughappliesaboveinthe
GoldenTelecomcaseaweightedaveragebetweentwodifferentbetacalculations.

INRERURAL/METROCORPORATIONSTOCKHOLDERSLITIGATION,March7,2014
(http://blogs.reuters.com/alisonfrankel/files/2014/03/inrerurallasteropinion.pdf)

INRERURAL/METROCORPORATIONSTOCKHOLDERSLITIGATION,October10,
2014(http://courts.delaware.gov/opinions/download.aspx?ID=213250)

APPELLANTRBCCAPITALMARKETS,LLCSOPENINGBRIEF,May19,2015(http://w
ww.thecorporatecounsel.net/nonmember/docs/05_15_RBC.pdf)

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