Shady Practices of Czech Court Experts
Court experts play a decisive role in looting property of portfolio investors. Their expert valuations establish the lower limit of compensation for squeezed out shares.
Czech so-called experts got their "expertise" based on a self-study, the quality and result of which no one verified. There are no regulations for valuation in the Czech Republic, so that so-called experts can value enterprises, or rather shares, as they please. The vast majority of so-called experts have no experience with an investment capital market, where they could test their (nonsensical) valuation procedures.
Domestic professional literature dealing with the valuation of enterprises, or rather shares, in the Czech Republic is poor, which corresponds with a short history of the local capital market. There was no capital market here during communism until coupon privatization. As for the domestic theoretical sources, almost all Czech so-called experts refer in their assessments to the legally non-binding publications of Prof. Milos Marik from the Prague University of Economics. Regarding the estimation of "true market" value of a company, or rather company issued shares, this Prague professor recommends to use the DCF valuation method in conjunction with the CAPM method. This pricing works in such a way that an appraiser first establishes the cost of capital. This means that an appraiser grants to the owner of the company, or rather its shares, a certain rate of annual appreciation of owner’s cash contribution into the company, or rather shares, as he deems adequate. For that, he puts together a forecast (divination) of the future business activity of the appraised company, and makes an estimate of the amount of future returns (free cash flow). Finally, the appraiser discounts the estimated future returns (free cash flow) to the date of valuation by a so-called discount rate, which is derived from the established cost of capital (or in combination with the cost of borrowed capital, using the method WACC if the appraised company uses credit).
Experts can choose the content of a forecast and the discount rate more or less freely. Cash flows based valuation of stock prices is therefore based on two variables whose values depend on the expert while the calculation does not contain any objectively given value.
An indirect proportion exists that the higher the cost of equity (i.e. the higher the rate of annual appreciation of the cash investment) the appraiser grants to the owner of the company, or rather shares, the higher the discount rate and the lower the value of the company, or rather shares, resulting from the appraiser’s calculations.
The source of the CAPM method, as applied in the Czech Republic, is the history of the American capital market because this market is supposed to be the “most credible” for obtaining objective data. Statistical data can be compiled based on a comparison of long-term returns from shares and bonds. According to these statistics, one can determine the average free cash flows of the U.S. stock market as a whole and compare it with the average yield on U.S. bonds (both are historical figures). These data show that the American stock market as a whole had in a long-term average a higher return than U.S. bonds. The difference between the two types of return is called risk premium for the U.S. stock market. For the shares of a particular company, the risk premium is further adjusted using a beta coefficient that reflects the fact that some categories of business were (are) more risky than others.
The problem is that the results of statistics vary depending on the period from which they are drawn. An appraiser can influence the result of the average free cash flows of the equity market by choosing the time period that he assesses. In most cases, the so-called experts are using the time series of U.S. capital markets since 1928 to the present, while that is not governed by any legal regulation. Based on this period, the average free cash flows of the U.S. stock market as a whole is around 6,5% per annum (minus inflation). Despite the doubts, we also accept that in the past, the average net free cash flows of the U.S. stock market were less than 7% per annum, net free cash flows of bond market about 2% p. a., and that the average difference between stock and bond market was therefore about 5% p. a. in favor of stocks (detailed data for a particular period can be found at the website www.damodaran.com). Experts call this difference of about 5% in free cash flows between markets a “stock market country risk” (Czech acronym RPT). Regardless of any doubts, let us accept as well another simplistic presumption of the so-called experts that the average growth rate of free cash flows of U.S. enterprises will be the same as in the past.
The Czech Method
For their valuations, so-called experts assume that the RPT in the past will be about the same as in the future. An obvious error then is that they consider the average free cash flows of the U.S. stock market (for a particular company adjusted by a beta coefficient for its industry) as a constant for a new stock investment, regardless of the actual price level of the market at the time of purchase. This is completely wrong, even if we accept the assumption that the future average growth rate of returns of U.S. enterprises will be the same as in the past. Let us have a closer look
how so-called experts proceed in the valuation of Czech shares.
First, the so-called experts pretend to calculate the amount of compensation for shares of Czech companies in such a way that the squeezed out shareholder is not worse off than before when he reinvests his compensation into similar (alternative) shares listed on U.S. stock exchanges, namely that he still maintains his expected free cash flows. That would be correct if we leave out the currency risk. However, it is completely wrong that experts do not take at all into account the current market price of shares in the market in the U.S. or in the Czech Republic. They do not take into account whether the alternative shares are expensive or cheap at the time of the squeeze out, and by how much. Expensiveness or cheapness of shares are generally expressed by the coefficient P / E.
In their valuations, so-called experts assume the future stock market return in the U.S. to be on average the same as it was in the past (calculated on the basis of statistical data from 1928 to present) but they do not specify the P / E ratio of the market at the time of a squeeze out. This is the same mistake, as if someone expected a certain return on specific shares for an investor but never even thought that it depends on what the purchase price is. No reasonable investor could operate that way because he would quickly go bankrupt.
To prove this error, you only need to ask any so-called expert to show in his expert evaluation where the current P / E of the stock market in the U.S. or the Czech Republic is in his calculations. He will have to say that nowhere. This guarantees that the expert valuation will be wrong.
The so-called experts are calculating a price for shares too low because they use a false assumption that the future average return of the stock market in the U.S. will be the same as the historical average returns when it was possible to buy shares cheaper than at the time of the squeeze out (measured by the coefficient P / E). If stock prices in the U.S. were calculated on the basis of this false assumption (let us call it the "Czech method"), it would turn out that the stock market in the United States should have according to the "Czech method" average P / E = 12.3. But at the critical time of the year 2005 when most cases of squeeze out happened in the Czech Republic, the shares MidCap 400 and SmallCap 600 (these shares are more similar to the squeezed out Czech shares than shares of the largest American companies) traded actually at an average P / E = 21,3. Therefore, the calculations of experts, arguably, have nothing to do with reality.
If the experts could use the "Czech method" to squeeze out American shareholders, they would give Americans only 58% of the actual market price of their shares (12.3 / 21.3) in 2005. Assuming for simplicity that the shares do not include any non-productive assets.
This explains the remarkable fact that in the Czech Republic, shares are bought out for financial compensation at a rate unlike anywhere else in the world. That is because the "Czech method” allows paying for shares substantially less than the fair price. As it is so important, let us repeat that in 2005, the "Czech method" lowered the actual market prices of U.S. stocks, according to which value Czech shares are measured, to 58%. Using the "Czech method", even American squeezed out shareholders owning U.S. stocks would be prevented from buying alternative investments with the same expected return and risk for the granted compensation, which violates the basic condition for the accuracy of an valuation of returns.
The Czech Method “Adapted to the Situation in the Czech Republic"
The CAPM method of valuation of shares, which is based on statistics of the capital market, can be applied not only in the U.S. but in other countries where there is a sufficiently long history of developed capital market. However, the Czech Republic does not belong to such countries. The capital market here is too young and too little developed that any meaningful statistics in accordance with domestic data could be compiled.
It is very interesting how Prof. Milos Marik deals with this fundamental problem in his publications. He proposes to base the calculation (estimate) of "genuine market" values of Czech companies simply on statistics from the U.S., and to lower the value of Czech firms, or rather shares they issued. According to Mr. Professor, Businesses in the Czech Republic always, and by default, have a lower "real market" value than comparable companies in the United States. Popular argument for this at first sight very strange approach is that the Czech Republic has a lower rating than the U.S., and therefore, it is supposedly necessary to use the higher cost of capital (to increase it by the risk premium for the so-called "country risk of the CR” – Czech acronym RPZ) in the valuation of Czech companies. The vast majority of Czech so-called experts accepted this method of valuation of Czech shares also for the purpose of the “squeeze out Czech style”. Of course, it is again wrong. Let us have a closer look how the so-called experts proceed.
It is to be noted that the methodology for calculating the cost of capital (that is the yearly percentage of free cash flows that the investor should expect from an investment into a particular company, adequate to the risk), that the so-called experts use for the purpose squeeze out, is based on an incorrect valuation philosophy. The so-called experts calculate the price for shares as if they wanted to compensate the U.S. investor for being forced by someone to sell his portfolio investments in the U.S. and instead buy from minority shareholders their Czech shares. If it were so, we would have to look at the whole matter through the eyes of a foreign investor, and it would be possible, for instance, to acknowledge his greater legal risk in the Czech Republic than in the U.S., grant him a higher discount for lower liquidity of Czech shares, or a generally higher level of risk arising for him from the foreign environment in the Czech Republic. However, that is not the situation with a squeeze out. It is exactly the opposite.
The so-called experts are supposed to calculate compensation for the Czech shareholders who are losing their shares against their will to the wishes of the principal shareholder. It is therefore necessary to look at compensation through the eyes of squeezed out shareholders. If the value of shares of the Czech squeezed out shareholders is based on the values of U.S. stocks, as it is being done, the so-called "country risk of the CR” (RPZ) must be first of all adjusted for RPZ + M, where M is the currency risk. M must have a negative sign, since as we said, the case must be judged from the perspective of the Czech shareholders. U.S. shares must be bought for U.S. dollars, and return on them is also calculated in U.S. dollars. If an appraiser wants to compare the economic value of Czech and U.S. companies, he must take into account currency risk. Every investor who does not want to lose money in reckless investments must respect this fact. If the so-called experts do not include currency risk M in their calculation of the "country risk", it is an obvious mistake. If the Czech shareholders bought U.S. shares for the received compensation in mid-2005 when the largest wave of squeeze out took place in the Czech Republic, they would lose by the end of 2006 about 15% of capital invested in dollars. This trend was obvious because from 2001 to 2005, the dollar lost about 40% to the CZK, and nobody expected this trend to change in 2005.
Instead of taking into account, for the benefit of squeezed out shareholders, the largest component of the economic "country risk" (RPZ), the currency risk C, the experts argue that the Czech Republic has a lower rating than the United States and therefore supposedly represents in terms of investment more risky territory than the U.S. Based on this reasoning, experts increase the cost of capital determined in accordance with the "Czech method" by the so-called risk premium for the "country risk of the CR” (RPZ).
A country rating expresses primarily the ability of a country to service its debts. Depending on the criteria of a particular rating agency, a country rating can express also other risks, including risks of a legal nature. Even if some "global investors”, when investing voluntarily, would reason the same way as experts calculate an adequate compensation (i.e. so that in exchange for higher returns in the Czech Republic in crowns they would be willing to accept lower returns in the U.S. in dollars), it would be necessary to analyze whether they reason correctly and why, and whether it is possible to apply the same reasoning also for a squeeze out. It is clear that stock markets, or rather the behavior of investors on the stock market is not affected only by economic but also legal risks, which are particularly high (with very poor protection of minority rights) for holding minority stakes in the Czech Republic. Every investor perceives the risk of damage to his property his own way and gives it weight according to his mentality and skills to defend himself. It is clear that in voluntary investment transactions, this type of legal considerations can play an important role especially for foreign portfolio investors. However, legal risks must not be included in the calculation of a share price in a squeeze out! If legal risks were included in the valuation also in a forced transfer of shares, it would allow the principal shareholder in the squeeze out to enrich himself at the expense of shareholders whom he squeezed out. This would mean that he could provide less than a full financial compensation to the squeezed out shareholders for their shares because he could say: As it is uncertain whether I rob you and how much, your shares have a lower price than in countries where tunneling and other ways of putting minority shareholders at a disadvantage is prosecuted more, better and more often. However, this is a totally immoral philosophy of valuation, based on the tolerance of an illegal status and absolutely unacceptable in a squeeze out.
From the perspective of a Czech shareholder, it is not correct to assume that investments in the U.S. are associated with a lower economic risk than domestic investments (in terms of legal risks, see the paragraph above). Above all, there is the before mentioned currency risk that the Czech investor must undergo while investing in the United States. The Czech Republic has a stable macroeconomic environment, relatively low debt ratio, relatively high economic growth, relatively low interest rates, Czech koruna is long-term among the world’s hardest currency, and from the economic and political point of view, it is part of a stable community of the European Union states. In the U.S., the Czech investors would also have to undergo the risk of an unfamiliar foreign environment. Active asset management (for example, attendance at Annual General Assembly, or defense against the iniquity that occurs in the United States as well) is for an ordinary Czech investor excluded in the U.S., which again increases his investment risk in the U.S.
We can summarize that if the so-called experts calculate the amount of compensation for Czech shareholders and determine it according to the values of American shares, the sum of RPZ + M must have a negative rather than positive sign, as is the normal practice. The Czech National Bank, for instance, could propose the amount of bonus for the squeezed out shareholders on the basis of statistics from the U.S., from which it is possible to calculate how much the price in a takeover bid exceeds the previous market price of the shares. The compensation should be increased by this bonus (rather than reduced, as it is happening in the Czech Republic!).
If the measure of the value of Czech shares is the American Stock Exchange, the basis of the value must be such a price of valued shares that would give to the seller the same expected discounted returns from reinvestment in the U.S. stock market as are the expected discounted returns for the buyer. We can call this value the balanced price. The balanced price depends on the market price of alternative shares (see the "Czech method" above). Only a tiny portion of the shares in the U.S. market is traded at the balanced price. If a buyer would like to buy many shares, he would have to increase the price substantially. Therefore, it is a standard in takeover bids in the U.S. to add a bonus to the previous market price. It is scandalous that in the Czech Republic, an expropriator not only does not have to give this premium but he is allowed to squeeze shareholders out for less than the balanced price! And how is it justified? Easy. The so-called experts say that the Czech Republic is a more risky territory in terms of investment. Of course, if the portfolio investors did not have to worry about being robbed in the Czech Republic, this argument would be completely irrelevant. Philosophy of valuation on which the so-called experts build their valuation is in squeeze out obviously incompatible with morality. It does not relate to reality even in voluntary transfers. How many shareholders would possibly voluntarily exchange Czech shares with a higher expected return (in crowns) for U.S. shares with a lower expected return (in dollars)? The Czech so-called experts should conduct a poll about this.
When the so-called experts do not achieve the desired result of a valuation, they simply increase the cost of capital granted to the investor (the main shareholder) by the so-called "specific risk premium" and thus further decrease the company value, quite arbitrarily, just so that they arrive at the result they want. "Specific risk premiums" should be called valuation manipulators, because any result of the valuation can be achieved with their help.
"Specific risk premiums" reflect a subjective judgment of a so-called expert about the level of discount of economic value, at which an owner of shares should be willing to sell. By their nature, they are inconclusive and their use in the squeeze out is nonsense.
So-called experts give most commonly two reasons why they use discounts:
a) Because the company is small, or rather has a small market capitalization.
b) Because of poor liquidity of the listed company’s shares.
However, this reasoning has nothing in common with the economic value of an valued company, or rather its shares. In a cash flows based valuation, the economic value of shares is given by the financial plan (expected free cash flows) and the business risk. There is no evidence that when comparing small and large companies, there is a greater business risk in small companies, and it is not possible at all to objectively quantify the differences. If a so-called expert, while evaluating shares, measures the size of market capitalization and liquidity of shares, these are not economic considerations. Or can we perhaps say that shares not traded publicly have zero economic value because their market capitalization and liquidity is zero? Or at least, that the economic value of such shares is lower than if they were publicly traded? Of course not, because the economic value of shares does not depend on the size of a company that issued them, or whether the shares are admitted to trading at the public market.
The truth is that lower or no liquidity of shares causes a lower interest of portfolio investors to buy the shares, which under market conditions may lead to lower prices of the circulating shares. In order to sell low liquidity shares, motivated sellers often have to provide a rebate (discount) to the buyers. However, these are motivated sellers of shares. In a squeeze out, there are no motivated sellers of shares and it is therefore in the case of a forced transfer of shares illegal and immoral to use the discounts mentioned above. There is only a motivated majority shareholder, for whom market capitalization or liquidity of shares are not important because majority and 100% shares are almost never sold through anonymous markets (the price is determined on the basis of direct negotiations between the seller and the buyer). Giving discounts to motivated majority shareholders, for instance because the liquidity of shares is little or none, means giving them quite openly a full economic advantage in a squeeze out. The basic principle of equality of shareholders is replaced by the principle of dual pricing: total economic value of shares for the majority shareholder, and lower circulatory price of shares for minority shareholders. With the use of dual pricing, the majority shareholder is quite openly granted the right to enrich himself in a squeeze out at the expense of minority shareholders.
The accuracy of valuation based on cash flows with the method CAPM or DCF does not depend only on determining the amount of capital cost properly, but also that the appraiser properly carries out a forecast (divination) of the future economic development of the valued company. You can guess that in the case of Czech so-called experts, this is not so because most of them are not real experts and especially in the "squeeze out Czech style”, they do not have incentives to act impartially, but on the contrary.
Czech legislators could have realized the pitfalls of devising a squeeze out financial plan (and of reviewing it later) even if they did not think. All they had to do was to take into account professional literature published in Austria and Germany, where the Czech Republic took the basic principles of squeeze out (to be precise, creators of the Czech version of the law were able to “copy” only some passages of the foreign law and almost no provisions guaranteeing protection of minority rights). For instance, in the article Wert und Preis im neuen Recht des Squeeze-out (published in Juristische Blaetter, No. 7/2007), Martin Winner, Assistant Professor at the Vienna University of Economy (Wirtschaftsuniversitaet) says: “Every valuation refers to a prognosis of free cash flows a company is expected to achieve, and depends on uncertain expectations of the future. These problems associated with squeezing out partners are further complicated by the fact that the information about the real situation (of a company), necessary for a contingent increase of compensation, is usually available only to the main shareholder but not to minority shareholders (information asymmetry). However, the main shareholder is the least interested in releasing information that could lead to increased valuation. Understandably, that is the situation in the Czech Republic as well.
A financial plan (forecast of financial activity) of the valued company is the foundation of a cash-flow-based valuation. Due to the senseless legislation, the principal shareholder (who has the smallest interest in the financial plan being drawn up objectively) selects and pays an expert to draw up the financial plan. Experts usually base their financial plan forecast on the financial plan drawn up by the management who is in cohorts with the major shareholder. For the purpose of a squeeze out, managements project results so bad that a management anywhere in the world could not remain in office if it predicted such a negative development for a company under its leadership.
Yet it is desirable in the case of squeeze out from the perspective of the principal owners, and therefore it is happening.
The practice where the amount of compensation is dependent on the declaration of a biased person whether the future profit will be small or large, would be laughable if it were not pathetic, because it has such a hard financial impact on the property of squeezed out shareholders. If the forecasts were correct, the average forecasts of profit growth for all companies where a squeeze out was conducted would have to correspond approximately with the expected economic growth in the Czech Republic in the following period. The average profit growth is incomparably lower for companies in expert valuations that are available to us. This is a logical result of an illogical law, and a contrary result would be an incredible surprise.
The motivation of Czech experts to value as noted above can be explained by the fact that they are getting paid for the "expert valuation" by a principal shareholder. The sums of money they require are known from review proceedings to be in hundreds of thousands crowns. The amount of fees they receive for expert valuations supporting the level of compensation paid by principal shareholders depends on an agreement. It is logical that principal shareholders are much more interested in savings on compensation for shares than on fees that are paid to so-called experts and are incomparably lower than the compensation. It is advantageous for principal shareholders to financially motivate so-called experts as required, so that they meet their interests. The methodology used in the Czech Republic in the valuation of shares for the "squeeze out Czech style" is therefore the result of the common interests of principal shareholders and experts. That is, to save, or rather to profit at the expense of squeezed out shareholders.