David Saunders and Joe Skilton, Berkeley Research Group
This is an extract from the third edition of GAR’s The Guide to Damages in International Arbitration. The whole publication is available here.
The income approach
Income-based valuation methods explicitly consider the value of the future income expected to be generated by the asset over its remaining economic life. A common form of this approach is known as the discounted cash flow (DCF) method, which uses a financial model to estimate the value of a company, entity or project based on the future operational cash flows that the asset is expected to generate, discounted to a present value as at the date of valuation. The discount rate used in a DCF reflects both the time value of money and the risk associated with the future cash flows.
The DCF income-based valuation approach was indicated as the most-used valuation approach in a review of a sample of 95 cases carried out in 2015. The same study also highlights the increasing acceptance of income and market approaches over time.Another study, prepared by Credibility International in 2014, reviewed the largest 30 ICSID cases by size of damages awarded. They found that of these larger award cases, DCF was the most common basis of damages and was used in 10 of the 30 occasions.
The market approach
Market-based valuation methods rely on benchmarks of value derived from similar assets, or transactions in similar assets, to generate a relevant multiple and metrics of the asset being valued. Once this multiplicand has been derived, it is multiplied by the relevant metric of the asset in question in order to estimate the value of that asset. A comparison of similarities and differences between the asset being valued and the sources of the benchmarks is undertaken in order to enhance the relevance of the calculation. The most common multiplicand and, therefore, type of multiple, is based on a measure of financial information such as revenue, profitability, cash flow or the balance sheet. In particular, earnings-based multiples and multiplicands are widely used. There are also a number of industry-specific valuation approaches that are a type of market approach. These are separately discussed below.
The cost or asset-based approach
A cost-based or asset-based measure is a method of valuing an asset by reference to its component assets and liabilities. This method requires the identification of the relevant component assets and liabilities, and an assessment of their replacement value.
While a particular valuation approach may be applicable for one purpose, it will not necessarily be the most appropriate valuation approach in a damages context. Further, it can be a misconception that one valuation approach is technically superior to another, and, therefore, should automatically be regarded as the most appropriate valuation approach. Such a mindset can diminish the objectivity that has been applied in reaching a valuation conclusion.
Choosing the most appropriate approach, or approaches, to a valuation for damages purposes is a critical aspect of the overall valuation exercise that an expert should have carefully considered before submitting his or her report. In the majority of cases, valuers will have looked at a number of approaches and have either decided on one approach, supporting the results of that approach with the outcomes of using other approaches; or may have used a combination of approaches and weighting the outcomes, on some considered basis, to arrive at a conclusion on value. The choice of approach, or approaches, and the assessment of their appropriateness or weighting will depend on a number of factors.
In the following sections, we set out some of the main factors that experts, or a tribunal, may need to consider in assessing the appropriateness of a particular valuation approach. While not an exhaustive list of factors, the issues highlighted in the discussion below are likely to have a significant bearing on the selection of a valuation approach, or approaches, in many international arbitration cases.
Basis of valuation and how these parameters affect approach
When considering the appropriate valuation approach or approaches, it is important to take into account the specific circumstances that direct the basis of the valuation exercise that has been requested. These include the valuation date, the type of shareholding or interest being valued and any specific contractual or agreed valuation clauses.
Taking these in turn, first, the valuation date may have a direct bearing on the most appropriate approach that can be used as it will guide what information is likely to be available that can be used in the valuation. For example, if a set of detailed forecasts exists that could be used to prepare a DCF in the assessment of damages, consideration is needed as to whether this information: (1) was available as at the valuation date; (2) could have been reasonably known as at the valuation date; or (3) was out of date as at the valuation date. These considerations might impact the reliability of the conclusions of a DCF method, or the application of a forward multiple, based on such forecasts. Alternatively, the valuation date might be at a time that multiples derived from similar companies, sought in a market approach analysis, are difficult to use because of general market dislocation or specific news events (for example, fraud) at those companies, which would then impact the reliability of the market approach.
Second, the type of shareholding or interest being valued, and the rights attached to that interest, will also have a bearing on what valuation approaches are appropriate or the emphasis placed on various methods. For example, if an uninfluential minority interest in an asset is being considered, it is important to understand how the holder of that interest is able to generate a return on his or her holding. It may be the case that he or she is entitled to dividends but otherwise would have difficulty selling the holding. This may result in it being more appropriate to use a modified DCF focusing on the dividends being remitted to a particular shareholder, rather than a DCF that values the whole asset and apportions that value to the different shareholders. It may also be the case that there is no history and no prospect of future dividends over a reasonable term horizon, and that the uninfluential minority interest holder cannot force a sale of his or her holding. In such cases, one may need to consider if there is a likely exit path for this investor, for instance, the prospect of the whole asset being sold, before considering how to approach the valuation.
Finally, there may be valuation clauses in relevant agreements that direct the valuation exercise to be approached in a particular manner. For example, these valuation clauses may direct the valuer to value the holding based on a pro rata share of the value of 100 per cent of the asset, with no discounts or premia applied, or to specifically use the market approach as well as a specified basket of comparable companies.
Any valuation exercise that does not take into account the specific circumstances that direct the basis of the valuation exercise risks being unfit for purpose.
The impact of the asset life cycle and type of asset on approach
A further important issue to consider when deciding on an appropriate valuation approach is the stage that a company, entity or project is in its life cycle. In particular, this may drive the level of financial information that will be available, or impact the reliance that can be placed upon the available financial information or the ability to forecast future performance.
The potential impact on the use of the income approach
Well-established companies will have data on historical financial performance, which may include audited financial statements, business plans prepared at different times during the company’s existence, forecasts and budgets. This information provides the valuation practitioner with an understanding of the historical financial performance of a company or entity, and enables him or her to assess the reliability of forecasts and budgets that have been prepared by the company, or provide a reasonable starting point from which to construct forecasts of future financial performance.
A well-documented historical performance assessment, combined with the existence of forecast information for a multi-year period, is likely to enable the income approach to be useful in assessing value and assist in generating reliable valuation conclusions. These are important considerations that can be used to support what has become one of the most widely used valuation methods in international arbitration.
Alternatively, the track record of a well-established company may illustrate a pattern of highly volatile results, or high variances in actual results when compared to forecasts or budgets made for those periods. This may call into question the reliance that can be placed on forecasts contemporaneous to the valuation date.
Often with expropriation cases in international arbitration, an entity is a start-up that may have little or even no record of operating. These entities obviously do not have a substantial build-up of corporate knowledge about the performance of the company.
As explained by Newcombe and Paradell:
[n]ormally, the fair market value of a going concern that has a history of profitable operations may be based on an estimate of future profits subject to a discounted cash flow (DCF) analysis. The DCF method involves calculating the present value of future profits and assets to estimate the value that a willing purchaser would pay for the business. Present value requires that a discount factor be used to account for the fact that these are future profits. The World Bank Guidelines note that the use of DCF value is reasonable for a going concern with a proven record of profitability.
In the case of start-ups, it may, therefore, not be appropriate to use a DCF method (or other income approach) as there may not be much evidence on which an expert could conclude that any of the forecasts are reasonable. There are examples of tribunals rejecting a DCF valuation methodology based on the lack of historical data.
However, a lack of historical data does not necessarily preclude the use of a DCF method; it is necessary to assess the company involved or project in question. Consider the example of a resource development company (such as a mining or oil and gas operation) where there may be little or no historical data in respect of a particular field or concession that has yet to be developed. The valuation practitioner, and ultimately the tribunal, may still be able to gain confidence that forecasts produced by such an entity may have a reasonable basis if, for example:
- the forecasts are supported by other closely related entities with relevant experience (i.e., information from adjacent fields), or external evidence such as market or resource studies;
- the new project may be run by large multinational organisations or consortiums that will have had many years of profitable operations from developing fields behind them; or
- data may exist for similar fields or concessions that have been developed by other parties.
The potential impact on the use of the market approach
The stage of a company, entity or project in its life cycle can also impact the use of the market approach.
Some bodies, such as the International Private Equity and Venture Capital group, a body representing a number of private equity and venture capital firms, recommend that in a commercial context, the market approach is used for valuation and that the DCF method is used as a cross-check. However, it is important to consider the differences between the company, entity or project being valued and the comparators that are used to derive valuation benchmarks, including differences in the stage of the life cycle. For example, if the asset to be valued is a mature company, while all its ‘peer’ companies are still in a start-up or early life-cycle phases, it may be difficult to derive meaningful valuation benchmarks, placing a limitation on the utility of a valuation using the market approach.
Additionally, if the company is operating in an industry that has only a few comparable companies, those comparable companies may be impacted by company-specific issues that are difficult to disentangle from their ordinary operations. This may impact the relevance of any valuation benchmarks derived from these comparable companies, limiting the reliability of valuation conclusions that are based on a market approach.
The potential impact on the use of the cost or asset approach
The company may also be at the end of its life cycle, either through a forced liquidation or where a decision has been made to cease trading, resulting in an orderly liquidation. In these instances, DCF or market-based measures would be inappropriate as they would consider the company as a going concern, when the intention is to dissolve the company.
A cost or asset-based approach, which considers what the component assets may generate and net of the cost of settling the associated liabilities, is likely to be an appropriate approach in such a case.
The use of industry-specific valuation approaches
In a number of industries, there are market approaches that are not based on ‘direct’ measures of financial performance, cash flows or the balance sheet and that may be commonly used by industry participants. These approaches instead tend to focus on a key performance indicator or core driver of either performance or cash flow generation. Although these industry-specific valuation approaches may not be sufficiently robust to be used as the sole method of deriving a valuation for damages purposes, such industry-specific valuation approaches are not without use and can be usefully employed by valuers or tribunals as a cross-check on the conclusions of value presented by other approaches.
For example, there may be circumstances in which an oil and gas company or project is still in the exploration phase (and likely still generating losses or only small profits) and a profit or cash flow multiple may, therefore, not be a reliable measure of value. In such a case, the future profitability of the project may be assessed through consideration of the hydrocarbon reserves and resources held by the entity and identifying other companies with similar levels of resources. Various multiples can then be estimated from these comparable companies and by reference to the ratio of enterprise value to the reserves (be that proved, probable or contingent reserves or combination of these). Finally, these multiples could be applied to assets being valued in order to estimate a potential value of the project, or at least benchmark the values calculated through the application of the income approach, market approach, or cost or asset-based approach.
Another example is that of the hotel industry, where it is possible to value a hotel based on the number of rooms relative to other comparable hotels. If using this methodology, for damages purposes or commercial purposes, it would be necessary to undertake a detailed analysis of the comparable hotels. One would want to consider the values of hotels that are in a similar location (both geographically and, if necessary, in the same part of a particular city, for example, the city centre), within a similar category and offering a similar level of service (for example, five-star hotels). Additionally, any differences in the number of rooms, typical occupancy levels, food and beverage offerings and other facilities (for example, conference facilities or existence of a golf course) offered by the comparable hotel would need to be assessed to draw meaningful information that could then be applied to the subject asset being valued.
These industry-specific valuation approaches are useful components of an overall valuation where they are widely used and accepted by industry participants.
The impact of the complexity of and the subjectivity inherent in the various valuation approaches upon selection of approach
Each of the valuation approaches has merit from a technical perspective. However, in executing certain approaches, the impression can be given that some methods are more complex than others, resulting in a false air of rigour if, in fact, there have been many subjective assumptions made that have not been well considered.
For example, in a DCF, if each of the components of the cash flows that are to be discounted (such as revenue, each type of cost, working capital and capital expenditure) are extensively modelled, the forecasts might consist of numerous large and complex sets of calculations. This may take an expert many pages of a report to adequately explain to a tribunal, giving the impression that the analysis is firmly grounded from a technical valuation perspective and lend a sense of accuracy to the conclusions that they perhaps do not warrant. Alternatively, the expert may not have presented the calculations or provided sufficient clarity in their explanation of the financial model, such that the primary assumptions become difficult to follow and do not provide tribunals with the assistance that they require.
A side effect of the introduction of detailed line-by-line modelling, which sometimes may be unavoidable and is done with the aim of improving the accuracy of the output, is that the size of the financial model is substantially increased. The larger the financial model is, the greater possibility there is of modelling errors. For this reason, and especially in cases where both parties agreed that a DCF is the principal method that should be used in the valuation, tribunals may ask the experts to seek agreement on a single working model to remove the risk of modelling error.
A phrase often used in modelling, or calculations, is that of ‘rubbish in, rubbish out’, meaning that the outcome of a financial model is only as good as the quality of the input assumptions. There are two aspects of the assumptions, in particular, that are useful to consider further in this regard:
- The first is that the introduction of subjective assumptions can result in substantial volatility in the overall conclusions when only small changes are made to certain of those assumptions. This can be exacerbated when there are numerous such assumptions. Sensitivity analyses are a useful tool to establish how the model outcomes change as a result of changes to assumptions. This assists in highlighting those assumptions that have a greater effect on value conclusions, allowing valuers, counsel and the tribunal to focus on the reasonableness of those key assumptions.
- The second aspect is that assumptions can often be interrelated. For example, it may not be reasonable to assume a large increase in sales volume is possible without considering if the market would be able to absorb the additional volume of sales without an impact on sales price. Instances of this nature require an expert to demonstrate that a considered understanding of the asset has been formed and taken into account, or potentially, that additional relevant expert input has been adduced on industry and commercial aspects of the case.
Similar principles extend to the market and cost or asset-based approaches. The market approach can often be considered to be attractive as it is easy to follow, with only two primary subjective inputs (the multiple and the multiplicand). However, each of these require sufficient analysis and understanding of both the asset being valued and each of the comparable benchmarks. In addition, there is often subjectivity around appropriate sampling of comparable assets, premia or discounts that may be required and adjustments made to the multiple or the multiplicand. Once again, a balance needs to be struck between conducting this comparable analysis in a sufficiently detailed manner to yield a reliable conclusion and the introduction of numerous areas of subjectivity.
It is not recommended to assume that one valuation method is universally superior to another in damages cases. There is a range of issues to be considered, including potential contractual considerations, asset-specific issues, the ability to prepare each of the various valuation approaches and the quality of outcome from each of the approaches. These will all impact the final choice of the appropriate valuation approach or approaches for the case in question. Ultimately, it may be that the outcome of a single piece of analysis is preferred over others, or that a combination of the valuation outcomes from a number of methods are considered relevant.
Therefore, the critical question of what is the appropriate approach, or combination of approaches, to apply in a valuation exercise, can only be determined through consideration of the specific facts and available information on a case-by-case basis.
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