The Fallacy of Adjusting Valuation for Growth and Inflation

Abstract

It has become almost standard practice in Delaware appraisal proceedings for the courts to adjust discount rates downward by the projected rate of inflation and GDP growth so as to reflect the prospect of higher future returns because of these factors. Since the value of a business varies inversely with the discount rate, the result of applying lower discount rates is that appraisal plaintiffs enjoy larger awards. But these adjustments to discount rates determined under the capital asset pricing model (CAPM) are wholly erroneous. They reflect a basic misunderstanding of CAPM as well as the discounted cash flow (DCF) method of valuation.First, these adjustments ignore the fact that returns from both inflation and growth are already built into the market rate of return as determined under CAPM since that rate is derived from historical averages that include both inflation and growth. Thus, to subtract these components of the required rate of return from the discount rate is to negate the model itself.Second, to adjust the discount rate because of the prospect of growth reflects a misunderstanding of cash flow as a measure of return. Ordinarily, growth requires reinvestment of some portion of available cash. But cash flow is a measure of the potential for distributions to investors. If cash is used to grow the business, it cannot also be distributed to investors. Thus, it is wrong to adjust the discount rate for growth without also adjusting return (as measured by cash flow) for capital spending. If both such adjustments are made, the resulting valuation is unaffected (except where growth opportunities offer rates of return higher than the cost of capital).The result of these errors is to increase values found in appraisal proceedings, to raise deal prices, and to encourage litigation, all to the ultimate detriment of stockholder wealth. The simple solution is to require appraisal plaintiffs to demonstrate – by company-specific evidence – that the subject company has identified and can exploit investment opportunities that will yield returns in excess of its cost of capital – economic rents – for some determinable period of time. But it is never appropriate to adjust for growth or inflation in perpetuity as many courts have recently ruled.