Appraisal Rights and Economic Growth

Abstract

In disputes relating to valuation, the courts prefer the discounted cash flow (DCF) method and the capital asset pricing model (CAPM). The usual approach is to calculate value year-by-year for the coming five years (the projection period) and to use projected average cash flow to calculate value for the period thereafter (the terminal period). Since cash flow differs from GAAP earnings by netting out funds reinvested in the firm (plowback), future returns can be expected to grow. Thus, one must adjust for expected growth during the terminal period. The standard practice is to reduce the discount rate by the projected inflation rate plus the GDP growth rate, since a firm must keep up with inflation (lest it disappear over time) and since economic growth comes from returns generated by business. But if plowback generates return at the same rate ordinarily required of the firm, growth in value will equal plowback. Thus, it is simpler to use projected GAAP earnings as the measure of return. To use cash flow together with an adjusted discount rate is akin to making Maraschino cherries – which are first soaked in lye to remove color and flavor and then soaked in food coloring and sugar to put it back. The question is whether long-term growth in firm value is limited to growth from plowback. There is good reason to think so since opportunities to generate above normal returns (economic rents) are likely to dissipate quickly because of competition. Still, it is possible that firms do grow by more than can be explained by plowback. But data are to the contrary. Since 1930, S&P 500 growth can be fully explained by plowback (GAAP earnings less dividends) together with reinvestment by investors. While plowback has been just enough to match inflation, remaining growth in stock prices is slightly less than would be expected by dividend reinvestment (consistent with diversion of some portion to consumption). The data since 2000 is somewhat different in that plowback has been less than inflation, but stock prices have nonetheless increased consistent with reinvestment. The bottom line is that real stock prices seem to grow slightly more than the real growth rate but a bit less than plowback plus the likely reinvestment rate. It follows that as there is no reason for stockholders to expect any more growth and no need for courts to struggle with estimating growth rates. By using projected GAAP earnings as the measure of average long-term return, the courts can use an unadjusted discount rate to calculate terminal value.