What Is an Appraisal Right?

An appraisal right is the statutory right of a corporation's shareholders to have a judicial proceeding or independent valuator determine a fair stock price and oblige the acquiring corporation to purchase shares at that price.

An appraisal right is a protection policy for shareholders, preventing corporations involved in a merger from paying less than the company is worth to the shareholders.

Key Takeaways

  • An appraisal right is a legal right of a company's shareholders to demand a judicial proceeding or independent valuation of the company's shares with the goal of determining a fair value of the stock price.
  • Shareholders typically invoke their appraisal rights when their company is being acquired or merged and they believe the price being offered is too low.
  • Different valuation methods can be used to determine the fair price, including asset-based methods, income or cash flow methods, comparable market metrics, and hybrid or formula methods.
  • Appraisal rights are important investor rights that protect the investments of shareholders from unreasonable, opportunistic, or ill-timed offers for their shares.

Understanding an Appraisal Right

Shareholders typically invoke their appraisal right when they will be forced to give up their shares unwillingly, most often in a merger or acquisition. The shareholder would prefer to remain in their position but management has decided to proceed with the merger or acquisition, or the shareholder believes that the price being offered for the shares is too low. In either instance, a shareholder would exercise their appraisal right and demand that a court correctly value the stock.

Analysts may use multiple valuation methods in determining the fair stock price and value of the acquired company, including asset-based methods, income or cash flow methods, comparable market data models, and hybrid or formula methods.

Once an appraisal of the shares has been conducted and if the valuation determines that the value of the shares is higher than what was offered or paid, the shareholder will be compensated accordingly.

An appraisal right is a crucial element to investor rights, particularly for minority shareholders, whose voice is drowned out by a single controlling shareholder or group of shareholders. Appraisal rights protect the investment of shareholders against unreasonable, opportunistic, or poorly timed offers for the purchase of a company.

While most occurrences of appraisal rights are based on consolidation or mergers, they may also apply to instances when the corporation takes any extraordinary action that shareholders deem harmful to their interests. In mergers and acquisitions, appraisal rights guarantee that shareholders receive adequate compensation if a merger or acquisition overrides their wishes.

Appraisal Rights and Business Valuation Methods

As noted above, there are several ways to value a business and arrive at a fair stock price to appease shareholders. One way is an asset-based valuation, which focuses on a company's net asset value (NAV), or the fair market value of its total assets minus its total liabilities.

Essentially, this method determines the cost to recreate the business physically. Room for interpretation exists in terms of deciding which of the company's assets and liabilities to include in the valuation, and how to measure the worth of each. For example, certain inventory cost methods (e.g., LIFO or FIFO) will value the company’s inventory in distinct ways, leading to changes in the overall value of the company’s assets.

Another form of business valuation is using comparable earnings ratios, such as the price-to-earnings (P/E) ratio, to determine how a business stacks up against competitors. For example, if a company’s P/E ratio is the highest among its peer group, either it truly has a promising edge in the field (perhaps a new technology or acquisition in a new market niche) or it is overvalued (i.e., its price is too high, compared to its actual profits).

Finally, independent evaluators might use the discounted cash flow (DCF) method to arrive at an objective stock price in an issue of appraisal rights. In contrast with the comparables method, which is a relative valuation method, the DCF method is considered an intrinsic method, independent of any competitors. At its core, the DCF method relies on projections of future cash flows. These are then adjusted to get the current market value of the company.