Most attorneys who are familiar with business valuations know that the professional standards of business valuation accrediting organizations and the International Revenue Service require the consideration of three approaches to value a business: 1) the Asset approach; 2) the Income approach; and 3) the Market approach. Let’s examine the income approach.
In simplistic terms, the income approach is a present value calculation of a business’s anticipated future earnings. Valuators generally use one of two methods when applying the income approach; the Capitalization of Earnings method or the Discounted Future Earnings method. In a nutshell, the Capitalization of Earnings method projects future earnings based on past performance. The Discounted Future Earnings method projects future earnings based on projections prepared by management or an expert. The Discounted Future Earnings method is appropriate to use where the future performance of the business is expected to be significantly different from past performance, i.e. start-up businesses, high-growth businesses, or failing businesses. When applying the Capitalization of Earnings method, the past financial information should be reliable because it has actually happened. However, when applying the Discounted Future Earnings method an important caveat is the reliability of the financial projections. Let’s consider some examples.
“Fanciful” Projections in PetSmart Shareholder Appraisal Action
PetSmart shareholders recently lost an appraisal action because of unreliable financial projections. The Delaware Court of Chancery rejected the Discounted Cash Flow method valuation because the projections used were unreliable. The court stated, “[t]he management projections upon which Petitioners rely as the bedrock for their DCF analysis are, at best, fanciful and I find no basis in the evidence to conclude that a DCF analysis based on other projections of expected cash flows would yield a result more reliable than the Merger consideration.” In re Appraisal of PetSmart, Inc. (Del. Ch., 2017).
“Poster Child for the Deficiencies” in Adelphia Bankruptcy
The U.S. Bankruptcy Court of the Southern District of New York in the Adelphia bankruptcy case rejected the Discounted Cash Flow value because the projections were unreliable. The court stated:
As a matter of common sense, DCF works best (and, arguably, only) when a company has accurate projections of future cash flows; when projections are not tainted by fraud; and when at least some of the cash flows are positive. If either of the first two of those can’t be found to be true, the factual underpinnings of the DCF computation become unreliable; if the third of them can’t be found to be true, it’s difficult, if not impossible, to find that the cash flows, by themselves, justify the valuation. In instances where any of those premises is invalid, the propriety of any use of DCF (and the weight DCF conclusions should be given) becomes debatable at best. This case is a poster child for the deficiencies in that regard.
Adelphia Recovery Trust v. FPL Grp., Inc. (In re Adelphia Commc’ns Corp.) (Bankr. S.D.N.Y., 2014).
Discounted Cash Flow in Divorce – a Momentary Lack of Reason
I rarely rely on a cash flow projection created by the business owner in an equitable distribution case. Why? The owner wants the business to be worth as little as possible for equitable distribution. Thus, the owner’s financial projections for the business may be grossly understated.
A recent case involved such a Discounted Cash Flow value of a small business. The business valuator, hired by the business owner, performed a DCF value based on financial projections created by the business owner. The owner projected the annual revenues of the small business would decline from $572,000 to $50,000 within 3 years generating large losses. Are you kidding me! Is this a void of common sense or a momentary lack of reason?
The business valuator’s assertion that the discounted cash flow method based on the business owner’s financial projections is a reliable indication of value is completely wrong and misguiding. He is either attempting to mislead the finder of fact, or he has no understanding of the concept.
The income approach is a very liable approach to valuing a business that is used by both valuation experts and investors. However, when applying the Discounted Future Earnings method, caution must be exercised that the financial projections on which the valuation is based are reliable and not biased to affect the outcome. Otherwise, the valuation may not be worth the paper it is written on.