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The Guide to Damages in International Arbitration - Second Edition

The Applicable Valuation Approach

Introduction

There are a number of applications and uses of valuations. For example, valuations can be performed for tax purposes, accounting purposes, mergers and acquisition activity purposes, and, of course, damages purposes.

In valuations for damages purposes, including the assessment of damages in the context of the fair market value of an asset, there are generally three approaches that valuers use. A brief outline of these approaches is set out below, with more detail being set out in other chapters of this book.[2]

The income approach

Income-based 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.[3] The same study also highlights the increasing acceptance of income and market approaches over time.[4] 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.[5]

The market approach

Market-based methods rely on benchmarks of value derived from either similar assets or transactions in similar assets to generate a relevant multiple and metrics of the asset being valued to derive a multiplicand, which, when multiplied, 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 performance, 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 (see page 190).

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 principal features that direct the basis of the valuation exercise that has been requested. These features 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 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 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 used 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 the holder of that interest, rather than a DCF that values the whole asset and apportions that value to the holder of the uninfluential minority interest holder. 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.

A valuation exercise, even for damages purposes, that does not take into account the principal features 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.

Practical insight from experts on the ground