Independent Expert Valuation - Critique Part Four.

Discount Rate.


In producing a DCF Valuation, it is essential to knowledgeably and with full understanding choose a Discount Rate (DR) that makes sense in the future situation that we are attempting to describe.

In the interests of not putting you to sleep, I will not repeat here the actual meaning and relevance of the Discount Rate. I have covered that in previous posts, including the CSAG Valuation. Instead, I will discuss the Independent Expert's choice of Discount Rate.

Firstly, let's have another look at the DCF valuation table provided by the IE.

The important thing to notice is that a change of just 1% in the choice of DR makes a substantial difference to the final value. As an example, in Scenario 2, a change in DR from 14% to 13% results in the DCF value increasing from $3.76 to $4.21. (an increase in value of almost 12%).

So, how has the IE chosen his Discount Rate?

Here is what he says:

a cost of equity of 13.4% to 15.0% based on:

•  a risk free rate of 5.6% based on the five day average of the zero coupon ten year Australian government bond as at 4 May 2011.
•  an equity market risk premium of 6.0%
•  a levered beta of 0.8 to 0.9
•  a company specific risk premium of 3% to 4%, reflecting the high level of uncertainty associated with the growth potential of Cellestis’ product

The Discount Rate is calculated as RFR + (EMRP * Beta) + CP


This results in a Discount Rate of between 13.4% and 15%. Rather strangely, after calculating those figures, he has then actually used Discount Rates of 14% and 15% in his calculations.

Now, that is a quite conventional computation for calculating a Discount Rate. However, let's look at it item by item

Risk free bond rate (5.6%).
Nobody can really argue with that, the risk free bond rate is what it is. However, that is a pre-tax rate, whereas the IE states that he is calculating an after tax Discount Rate. Depending upon an individuals tax rates the actual return from investing in these bonds would be approximately 3% to 4%. If he is calculating an after tax DR then we would have expected him to use the after tax risk free bond rate. Alternatively, he could consider his DR as a pre tax DR and apply it to Cellestis' EBIT, rather than NPAT. Compare apples with apples.

Equity Market Risk Premium (6%).
This is where most people get a little confused. This premium has nothing at all to do with any perceived risks in the company that you have chosen to invest in. It is, in fact, a risk premium that is assigned simply because you are investing via the stock market (as opposed to some other market, such as the bond market, the real estate market, etc.). It is not a business risk, it is the risk of share prices going up and down on the stock market. It represents the extra return that you, the stock market participant, require because of the vagaries of share prices.

EMRP is generally calculated from the historical volatility of stock prices in the stock market as a whole.

Personally, as a long term investor, I am not particularly interested in EMRP. The reason for that is that I do not ever put myself in a position where I have to sell my investments at any particular time (I'm sure you can see the irony that the current event creates here). I have no reason to sell my investments in the times that the share market is weak. I invest in businesses and therefore do not consider that EMRP has any real relevance to me.

I understand and am happy to accept that others may feel differently.

Here is the crunch. If Qiagen are successful in purchasing Cellestis, then Cellestis will no longer be listed on the stock exchange. If Cellestis is not listed on the stock exchange then it is not subject to any share market volatility risk and Qiagen do not need to take that (now non-existent) risk into account when calculating what Cellestis is worth to them.

Levered Beta (0.8 to 0.9).
Firstly, for Cellestis, we can disregard the superfluous qualifier "levered". The difference between a levered and an unlevered Beta is purely based on the debt of the company. Cellestis has no debt and therefore there is no difference between the levered or unlevered Beta of Cellestis.

In simple terms, the Beta is a multiplier that is applied to the Equity Market Risk Premium to account for that fact that the market price of individual stocks have different volatilities than the market as a whole. The Beta of less than one that the IE is using tells us that the Cellestis share price is less volatile than the market as a whole.

The Independent Expert has therefore used an adjusted Equity Market Risk Premium of between 4.8% and 5.4%.

Company Risk Premium. (3% to 4%).
This is the premium return that an investor in Cellestis expects in exchange for the risk that things may not turn out as good as projected in the future earnings table.

The IE has not given any reason for seemingly arbitrarily selecting this Company risk premium so it is a little hard to sensibly analyse his choice.

My general comment here would be that the IE has produced an extremely conservative future earnings projection for Cellestis and then is still not happy with it so has discounted the value further by applying an arbitrary 3% to 4% risk premium. How you would actually do that with any level of justifiable confidence is beyond me.

In the end.

I am not going to tell you what DR the IE, or you, should use. However, I am absolutely confident that his 14% to 15% Discount Rate is significantly higher than that which any reasonable analyst would use. Remember that even a 1% change in the Discount Rate used will result in a very material change in the valuation calculated.

The compounding of the IE's incorrect assumptions, miscalculations and errors has resulted in a valuation of Cellestis that I cannot in any way rely upon in making my decision about this offer by Qiagen.

Vic
Spokesperson
CSAG

Disclaimer. Nothing in this document should be construed as personal financial or legal advice. All information is provided on the understanding that you will take whatever steps are necessary to ensure that any actions that you take are the most approriate for your own personal circumstances. The author accepts no responsibility for the impact of any consequent outcomes.