Fri, Jul 9, 2010

Client Alert: Delaware Chancery Court Fails to Adopt the Morningstar/Ibbotson Historical Equity Risk Premium; Opts for Lower Estimate, Effectively Increasing Valuation

An April 23, 2010 decision by the Delaware Court of Chancery may have a broad impact on how discount rates used in valuation models are determined.
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In Global GT LP and Global GT LTD v. Golden Telecom, Inc. the valuation decision was hinged upon the methodology used to develop two key inputs in developing cost of capital estimates: the beta and the equity risk premium (ERP).

Certainly, the Court's findings shed important insights into a beta's proper derivation (in this case, at least), by focusing on whether a traditional 60-month historical beta or, alternatively, an adjusted (a.k.a. "forward-looking") beta is more pertinent to the valuation. However, the ramifications of the Court's failure to adopt the Morningstar/Ibbotson "historical" equity risk premium and instead opting for a significantly lower estimate is far more consequential.

The Court's decision on ERP is consistent with the position that Duff & Phelps has advocated for several years. In fact, the Court cited the work published by Duff & Phelps' Managing Director, Roger Grabowski, and Dr. Shannon Pratt on a number of occasions. Duff & Phelps incorporates its latest analysis of academic and professional research on the topic of ERP in its annual Duff & Phelps Risk Premium report.

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