Valuations

Introduction

The phrases “market value”, “fair market value” and “fair value” mean roughly the same thing, right? Wrong.  A recent case confirms the legal meaning of “market value” and in doing so demonstrates how critical the choice of value expression can be.

Who needs to know?

Businesses, debt and equity investors and corporate finance advisers who deal with structures that involve independent determinations of value. It’s also particularly relevant to independent experts who are appointed to undertake valuations.

Background

The case of International Petroleum Investment Company v Independent Public Business Corporation of Papua New Guinea [2014] NSWSC 1289 relates to $1.6 billion of bonds that were issued by the Independent Public Business Corporation of Papua New Guinea (Issuer), a corporate financing vehicle for the PNG Government. The bonds were issued to International Petroleum Investment Company (Holder), a company based in Abu Dhabi. Please click here for a copy of the case.

The bonds were issued to help finance the PNG Government’s interests in Oil Search Limited, a PNG company listed on the ASX. Oil Search has investments in many oil and gas projects in PNG, including the US$19 billion ‘PNG LNG’ project operated by ExxonMobil which made its first deliveries of LNG during May 2014.

Under the terms of the bond deed poll, the bonds were set to mature on 5 March 2014. Rather than being repaid in cash, the bonds were subject to a mandatory exchange into 196 million ordinary shares in Oil Search. This exchange equated to $8.55 of bond principal per ordinary share. However, if on maturity the “Current Market Value” of the shares was less than the principal and accrued interest, the Issuer was required to pay the Holder a cash top up equal to the shortfall.

Under the deed, the “Current Market Value” of an Oil Search share was calculated as the volume weighted average price (VWAP) of Oil Search shares traded on the ASX during the period of 20 trading days up to the “Valuation Date” of 17 February 2014.

As it eventuated, the VWAP for the shares was only $8.19. The Holder therefore claimed it was entitled to a cash top-up of $103 million.

The deed contained an alternative mechanism which allowed the Issuer to determine the Current Market Value on a different basis if it believed that the Current Market Value derived from the VWAP did not reflect the “market value” of an Oil Search share. Under the alternative approach, the Issuer and the Holder would appoint their own independent experts to determine the “market value”. The average of the two valuations would then be used for the purposes of calculating the shortfall payment (if any).

The Issuer invoked the alternative mechanism. It engaged RBC Capital Markets to be its independent valuer. RBC produced an alternative market value of $8.60 per share. The Holder engaged KPMG Corporate Finance. KPMG produced an alternative market value of $8.19 (which just happened to be the same as the 20 day VWAP per the normal mechanism in the deed). The average price was therefore $8.395 and this resulted in a cash payment of $62.9 million in comparison to the $103 million payment calculated per the normal mechanism in the deed.

The Holder objected to the valuation report produced by RBC. The Holder essentially argued that the RBC valuation was not valid for the purposes of the deed because it was not a valuation of “market value” (as required by the deed), but was instead a determination of some other value such as fundamental value or intrinsic value.

The Test for Market Value

The Court recapped on the leading authorities and confirmed that market value means the price at which a willing and knowledgeable but not anxious purchaser would pay, and a willing and knowledgeable but not anxious vendor would sell, in an arm’s length transaction.

The focus of market value is on the price actually obtainable in market sales. In other words, the prices at which shares in a company are being bought and sold on a stock exchange will typically represent their market value. The Court went on to confirm that the test for market value is to be contrasted with other tests such as for “fair value” and “fair market value”. The Court noted the distinctions can sometimes be difficult to draw, but they are “old and fundamental”.

Was the RBC valuation valid?

For the reasons described below, the Court concluded that the RBC valuation was not an assessment of “market value”.

Even though the RBC report expressly described its valuation as being a “market value”, the Court found that the report was in fact directed to some other notion of value such as the “intrinsic value” of the Oil Search shares.

Comparative Analysis

The RBC report contained extensive analysis of price to net asset value ratios and comparisons between Oil Search and its peer companies such as Woodside. The Court acknowledged that the use of comparables is an orthodox methodology in determining market value. However, in this case the RBC report took the comparison approach too far. After analysing the historical similarities between the price to net asset ratios of Oil Search and Woodside, RBC then essentially removed the impact of short term fluctuations in Oil Search’s share price so as to produce a so-called “true market value” which was more consistent with the historical relationship between the share prices of the two companies. The Court was critical of this approach:

Instead of taking the respective differences in performance between Oil Search (attributable to identified events) and Woodside as revealing differences in market value of their shares, the RBC valuation assumes that there is a fixed relationship between the market value of both and proceeds to eliminate the effect of the difference to bring them in to line, concluding that the result discloses the true market value of Oil Search shares. In my view, the starting premise that the market value of Oil Search shares can be derived by a comparison with the trading price of shares in peer companies is manifestly unsustainable, as is the elimination of the difference where that difference is attributable to the sentiment of an informed market … I consider the conclusion that the underperformance gap or part of it represents the difference between market price and market value to be fallacious.

Subsequent Events

Oil Search had previously made announcements in October and December 2013 which signalled a possible equity raising and a potential new acquisition. These announcements generally depressed Oil Search’s share price during the VWAP period in early 2014. However, Oil Search’s share price subsequently recovered as market sentiment improved and a further announcement was made by Oil Search on 27 February 2014 (i.e. 10 days after the valuation date of 17 February). The RBC report took into account these subsequent events. It argued that these subsequent events demonstrated that the true market value of Oil Search’s shares on the valuation date was in fact higher than the traded price.

Whilst the Court agreed that subsequent events can sometimes be looked at insofar as they illuminate the value of the shares at the relevant time, it disagreed with the approach adopted by RBC. The Court summed it up as follows:

The market factored into its prices the matters of concern identified by RBC. The allaying of these concerns by subsequent events are not facts which, if accepted, could rationally affect (directly or indirectly) the assessment of the market value of an Oil Search share on 17 February 2014 other than to confirm that the traded price on that day was indeed market value … On RBC’s approach if, after 17 February 2014, the investor concerns identified by it had been exacerbated rather than allayed leading to the price being depressed, or if Oil Search’s announcements had been more positive than they in fact were leading to the price rising, the performance gap noticed by RBC would be different, and accordingly the market value on 17 February 2014 would likewise be different. As at 17 February 2014 neither scenario was a certainty. The RBC approach makes no allowance for an alternative version of future history at that point. Logically and rationally in an informed market the price on 17 February 2014 cannot depend on future history at that point.

Asset Value

RBC argued that the price impact of Oil Search’s announcements should be excluded for valuation purposes because they were unrelated to the value of Oil Search’s underlying assets. The Court disagreed with this approach. The impact of these announcements should have been included when determining the market value of the shares because they clearly affected the price at which the shares were trading on the exchange. The Court summed it up as follows: “The RBC valuation is directed to attributing a value to an Oil Search share based on a valuation of Oil Search’s assets not on the value purchasers and vendors in an informed market were placing on an Oil Search share.”

Practical Points to Take Away

• The test of “market value” is focussed on the price at which the shares are trading in the market place. It may be that the true or fundamental value or target price of the shares is higher or lower than the trading price. This generally does not matter for market value purposes. Similarly, if the market is fully informed, it does not matter if (with the benefit of hindsight) it can be said that the market was underpricing the shares. The marked down price of a share affected by a specific factor known to the market is the market price at that point in time.
• The test of “market value” is probably the most objective and narrow valuation approach. There is very little scope to adjust the market traded price for other factors. In contrast, expressions such as “fair value” usually involve wider considerations of intrinsic value, as well as synergies and control premiums.
• The case contains detailed analysis of the RBC report as well as the approach taken by KPMG in its report. The details are too much to go into in this article, however, experts who regularly prepare valuations should read the case to see the Court’s views of the different methodologies adopted by RBC and KPMG, as well as the views expressed by other expert witnesses who gave evidence. Please click here for a copy of the case.
• Market prices can be volatile. Price movements may be stock specific or they may be caused by unrelated market wide events. Markets don’t always behave rationally. Timing can be critical, especially in relation to the price impact of ASX announcements. Even with a VWAP approach, lumpy trading and liquidity can have a big impact on the price. Parties need to be aware that there is a significant risk with using “market value” that you may not get a fair or intrinsic value. For example, in this case, the market value of $8.19 compared to the then average institutional research analyst target price of $9.64.