The Applicable Valuation Approach

Introduction

This chapter provides a discussion on the criteria that may inform the applicability of valuation approaches in various situations. As shown below, proper selection of one or more valuation approaches requires careful study of the facts of the case in question. In contrast with valuations made in the normal course of business, damages assessments are often undertaken retroactively or under specific performance instructions, which makes the analysis more complex and often calls for adapting to special circumstances, assumptions or counterfactual situations. Moreover, damages calculations are determined within the context of legal disputes when the remedy for compensation received by a damaged party is informed by legal standards that may place restrictions on the analyses and methodologies available to determine damages.[2] As such, there is not always an equivalence between the value of an asset, company or investment and the damages available to a claimant.

Given the wide array of situations with which tribunals and experts are presented, parties must resist the urge to try to find ‘one-size fits-all’ formulae. Rigid reliance and application of guidelines on damage and compensation approaches, as well as reliance on prior awards from other cases, may lead to erroneous suppositions regarding which valuation approach to apply in any given case.

In examining how to determine the applicable valuation approach, we first discuss the intent and principles of valuation. We then provide a brief description of generally accepted valuation approaches. Finally, we conclude with a worked example to demonstrate best practices for selecting the correct valuation approach.

Valuation approaches

Principles

At its foundation, the valuation of an asset or a company seeks to calculate the economic benefits generated by that asset for investors. It is therefore necessary to evaluate the operations of a business or asset to understand how value is generated by it. In most cases, companies and assets create (or are expected to create) value during the economic lifetime of their operations. As such, valuation approaches are generally forward-looking; that is, they measure the value of an asset or a company by assessing the prospects of its future operations.

If an asset is expected to produce cash flows for its investors, and credible estimates of key parameters such as revenues and costs can be ascertained, its value can be calculated using the income approach, which discounts those future cash flows to reflect the risk of producing them and the time value of money.[3] In some cases, valuation approaches, such as the market approach, rely on observations of market value, which implicitly include forward-looking prospects without revealing the details behind those market value determinations, to assess the value of an asset against a similar peer group. Alternatively, if a company is not expected to continue to operate, its value may be determined using the cost approach, or what investors could receive if the company were liquidated. Although these approaches differ in methodology, each determines the value of an asset by evaluating its future use.

In the following sections, we discuss the income approach, market approach and cost or asset-based approaches in more detail. Although the value of a company or asset can be determined using different approaches, the intent of a valuation is to determine how much value investors can receive from a given valuation date forward.

Income approach

The income approach is used to determine the value of an asset based on the ability of that asset to generate cash flows during its economic useful life. The most common application of the income approach is the discounted cash flow (DCF) method, which is considered ‘the foundation on which all other valuation approaches are built’.[4] The DCF method calculates the value of an asset as of a given valuation date to be the ‘present value of expected cash flows over its life, discounted to reflect both the time value of money and the riskiness of the cash flows’.[5] The expected cash flows stemming from an asset are composed of the following main components: expected revenues, minus expected cost and expenses (e.g., operating expenses, general and administrative costs), minus capital expenditures and minus applicable taxes. The DCF method can be used to calculate the enterprise value of a business (i.e., the combined value of a firm’s equity and debt) or the value of a business’s equity directly.[6]

Importantly, the DCF method is based on principles of financial economics and often is considered the preferred valuation methodology for income-generating assets.[7] As noted by valuation scholars Thomas Copeland, Tim Koller and Jack Mullin: ‘The DCF approach captures all the elements that affect the value of the company in a comprehensive yet straightforward manner. Furthermore, the DCF approach is strongly supported by research into how the stock markets actually value companies.’[8]

For example, in Suez v. Argentina, the tribunal used the income approach to assess damages because ‘the value of an asset or business is best determined by calculating the stream of income or benefits that it will yield its owner and then discounting that stream of income to present value using an appropriate discount rate’.[9]

Market approach

The market approach is premised on the idea that similar assets, whether a house or a share of stock, should sell for similar prices.[10] To calculate the value of an asset using the market approach, it is necessary to determine (1) a set of assets comparable to the one in question; and (2) standardised prices, often expressed as a multiple of a known variable, such as earnings, profits or revenues,[11] though sometimes as guided by industry standards.[12] The target asset’s value is then assessed by multiplying a relevant metric by the appropriate multiple from the comparable assets.

Though often preferred as a valuation method because of its simplicity and ease of use, the market approach can lead to erroneous outcomes if misused. Proper use of the market approach requires that (1) the set of comparable assets be priced by the market,[13] (2) market prices be scaled to a common variable, and (3) adjustments be made for differences across assets.[14] For example, in the context of determining the price of a car, one would expect to use published prices from dealers, that a small sedan would not be priced similarly to a large SUV, and that a new car with modern amenities would be expected to have a higher price than a used car in need of repairs. To determine the price of the car properly, one would have to account for each relevant factor that drives value.

The market approach also is often used both by itself and in support of other approaches, such as the income approach. For example, in OI European v. Venezuela, the tribunal acknowledged that a ‘commonly accepted formula for checking the valuation of a company calculated based on DCF is to repeat the calculation using the EBITDA multiples method’.[15] In other awards, such as Crystallex v. Venezuela, the market approach was selected as the preferred methodology to assess damages. The tribunal indicated that ‘such method is widely used as a valuation method of businesses, and can thus be safely resorted to, provided it is correctly applied and, especially, if appropriate comparables are used’.[16]

Cost or asset-based approach

A cost approach or asset-based approach is based on the economic principle that an asset’s value is at least equal to the cost of purchasing or constructing a substitute asset of comparable utility.[17] This approach assumes that the subject asset is fungible, meaning ‘substitute properties of comparable utility may be obtained’.[18] When using an asset-based approach, the value of a firm often is computed by assessing the net book value of its assets and liabilities, updated to reflect the current market value.[19] As in the market approach, market prices of assets implicitly contain forward-looking estimates of those assets’ ability to generate future income for investors. However, the tribunal in Siemens v. Argentina explained that ‘the book value method applied to a recent investment is considered an appropriate method of calculating its fair market value when there is no market for the assets expropriated’.[20]

Examples of the use of the asset-based approach can also be found in Asian Agricultural Products v. Sri Lanka[21] and Phillips Petroleum v. Iran.[22]

Selection of valuation approaches to conduct damage assessments

Introduction

It is often tempting, when selecting the applicable valuation approach, to rely on established guidelines and previous tribunal awards. However, rigidly applying guidelines on damage and compensation approaches, as well as strict interpretations of tribunal awards in other cases, can often lead to the use of inappropriate valuation approaches.

In the following section, we explain that (1) the strict adherence to guidelines may lead to the inappropriate exclusion of reliable and valid valuation approaches, and (2) the analysis of key case-specific facts, information and data is crucial in determining and implementing the appropriate valuation approach.

Overview of guidelines commonly used for selecting a valuation approach

Multiple guidelines are available to assist in determining the applicable valuation approach when valuing a company or a project, such as those promoted by the International Valuation Standards Committee, American Society of Appraisers, American Institute of Certified Public Accountants or the World Bank.

In particular, the World Bank Guidelines on the Treatment of Foreign Direct Investment regarding ‘Expropriation and Unilateral Alterations or Termination of Contracts’ are widely referenced by practitioners and tribunals to identify and support the use of applicable valuation approaches.[23] The World Bank Guidelines provide three approaches for determining the fair market value (FMV) of an asset: (1) the DCF ‘for a going concern with a proven record of profitability’;[24] (2) the liquidation value for an asset that is not a proven going concern and that demonstrates a lack of profitability;[25] and (3) the replacement value for other assets (or book value when it reasonably approximates replacement value).[26]

Guidelines such as those presented by the World Bank, although sometimes useful references for the selection of the applicable valuation approach in the context of quantum of damages assessments in arbitration cases, present certain limitations that should be considered. As Professor Marboe explains in connection with the World Bank Guidelines, these guidelines are ‘recommendations and do not have a binding character’.[27]

Limitations

First, guidelines may not contemplate or discuss all relevant valuation approaches that could be viable and reliable in the assessment of a company or a project. For example, the World Bank Guidelines do not indicate the market approach as one of the recognised approaches for the determination of FMV. However, as explained above, the market approach is a generally accepted valuation approach used by academics, valuation practitioners, companies and investors, and tribunals, and in fact is the preferred approach in many circumstances.

Second, although guidelines often suggest which valuation approaches to apply and when to apply them, these suggestions, if taken at face value and applied rigidly, tend to lead to unsupported conclusions and flawed results. For example, the World Bank Guidelines seem to suggest that a crucial factor for selecting the DCF approach to determine FMV is whether the company or project at issue is a going concern with a track record of profitability.[28] Yet past indications of profitability are not a guarantee of continued success, and therefore the notion that a company by virtue of being a going concern is more able to predict its future cash flows is not always correct. For example, a going concern that faces market disruption may be in a weak position when it comes to forecasting its future cash flows; on the other hand, a natural resource-based start-up that relies on well-studied geology, costs and feasibility studies, and that plans to sell its product in a commoditised market with clear price signals, may be in a better position to forecast its future cash flows. Further, as we demonstrate below, identifying a going concern is not as simple as evaluating whether it fits a definition.

To illustrate, we examine the logic behind a strict interpretation of the definition of a going concern in the context of valuing competing transportation companies in New York City, specifically taxi licences and companies operating with rideshare apps, such as Uber and Lyft. Taxi licences in New York (or medallions, as they are known) were profitable (and thus, quite valuable) for decades prior to the launch of rideshare apps. However, at the point when Uber and Lyft entered the market, the profitability of taxi licences was no longer assured, though any projection of future success based solely on historical data would have suggested the opposite at that time. However, in the case of Uber and Lyft, it would be inappropriate to conclude that these two companies were not going concerns until they had successfully supplanted taxis in New York City. In fact, estimations regarding the future market size of taxi transportation in New York City, and demand for transportation services and future profits, could be performed around the time that Uber and Lyft entered the market. As such, the continued operation and expected future cash flows of Uber and Lyft, both critical elements for the DCF method, would have been knowable at that time.

Notably, the published prices for medallion transactions fell around the time rideshare apps entered the transportation market in New York. Consequently, a market approach comparing the price of a medallion with actual observed market transactions would have provided significant insight into the value of a taxi licence in New York, for anyone interested in valuing them at that time.[29]

As we explain in more detail in the next section, the observation and analysis of key case facts and data are critical in the selection of the appropriate valuation method and in the construction of a damage framework that leads to robust and reliable results.

Basis for selecting valuation approaches

The selection of valuation approaches should be based on the predictability of cash flows and not on a cookie-cutter approach based on guidelines. We analyse the selection process of the applicable valuation method in a hypothetical case and illustrate that (1) rigid interpretations of guidelines lead to erroneous suppositions regarding the applicable valuation approach, and (2) case facts are of fundamental importance in the selection and implementation of the proper valuation approach.

In 2013, Fertiltech Corporation (Fertiltech) – a company specialising in the construction and operation of fertiliser plants – after performing due diligence in different potential projects and investments, entered into an agreement with the government of the Republic of Landonia (Landonia) to develop and run a fertiliser production facility located in Landonia. In 2014, Fertiltech and Landonia entered into a 25-year offtake agreement, which established the following key terms:

  • Landonia committed to purchase the entirety of the annual output of Fertiltech’s fertiliser production facility over a 25-year contract term;
  • the sales price of the fertiliser was set at US$200 per ton; and
  • the contract included a mechanism that adjusted the sales price over time based on actual inflation in US dollars.[30]

At the end of the 25-year contract period, Fertiltech was expected to sell the fertiliser produced at market prices.

From 2014 and 2017, Fertiltech invested US$35 million in the development of the plant, including (1) the purchase of land, (2) the commissioning of technical feasibility studies and (3) initial construction costs. Further, based on third-party engineering studies and business plans, the project was expected to start production in June 2018. However, in December 2017, Landonia enacted a law that nationalised corporations operating in certain industries, including the chemical sector, which encompasses fertiliser plants. In January 2018, Landonia expropriated Fertiltech’s investment in the country. Consequently, Fertiltech lost its investment and sought compensation for the damage suffered.

As explained above, according to the World Bank Guidelines, the FMV of an investment like that of Fertiltech in Landonia could be determined based on one of three methods: (1) the DCF method for a going concern with a proven record of profitability; (2) the liquidation value for an enterprise that demonstrates lack of profitability; and (3) the replacement value or book value for other assets.[31]

We now consider the selection of the applicable valuation approach to determine damages stemming from the expropriation of Fertiltech’s fertiliser production facility by Landonia based on a strict interpretation of the World Bank Guidelines.

First, use of the replacement value or book value in this case does not seem appropriate. Assuming that the Fertiltech project was expected to generate positive economic returns, a seller would not be willing to sell its interest in the project for a value equal to the replacement value or book value. Consequently, in the case of Fertiltech, the use of this approach would violate the fundamentals of the FMV standard to determine compensation. Second, the use of the liquidation value approach is inappropriate because this project does not show lack of profitability, nor is it in financial distress. Third, the use of the DCF approach does not appear to be appropriate in the case of Fertiltech if one strictly interprets the World Bank Guidelines’ definition of ‘going concern’, which indicates that the assets being valued should be ‘in operation for a sufficient period of time to generate the data required for the calculation of future income’.[32] As such, the Guidelines alone do not offer sufficient guidance to determine the applicable valuation approach.

However, careful analysis of the terms set forth in the offtake agreement entered into by Fertiltech and feasibility studies reveal that the main inputs to determine the project’s cash flows can be reliably estimated, and thus support the DCF approach as the appropriate methodology to calculate damages. First, volumes of fertiliser produced and sold by Fertiltech can be reliably estimated based on the offtake agreement for 25 years. Similarly, sales prices can be determined under the offtake agreement; consequently, the revenues stream (calculated as volumes times prices) can be estimated with reasonable certainty as of the date of expropriation. Second, Fertiltech’s profit margins (revenues minus costs) tend to be protected from US inflation by virtue of an escalation clause included in the offtake agreement for 25 years that adjusts prices based on US inflation. Third, capital expenditure estimates are readily available in the feasibility studies commissioned in the development of the project. In addition, the technical and economic analyses provided within the feasibility studies available for the Fertiltech project corroborate the economic viability of the project. In conclusion, the expected cash flows stemming from the Fertiltech project as of the expropriation date can be reasonably projected.[33]

Despite this predictability, in certain cases, the use of the DCF model is criticised when applied to projects in development phases or for young companies because of the uncertainty surrounding valuation inputs. There are methodologies, however, that can be implemented to account for project-specific (or idiosyncratic) risks.

According to principles of finance and valuation, the present value of a stream of cash flows stemming from a company or project accounts for the risk factors associated with this company or project either in the cash flows or in the discount rate applied to these cash flows. Professor Aswath Damodaran explains that there are ‘two ways of adjusting for risk in project analysis. In the first approach, we estimate the cost of capital for individual projects, and we adjust the cost of capital for the riskiness of the projects. In the second, we look at ways of adjusting cash flows to reflect project risk’.[34] Therefore, consistent with this approach, the components of the cash flows (e.g., revenues and costs) or the discount rate applied should reflect risks.

When appropriate, certain project-specific risks can be accounted in the cash flows projections. For instance, in the case of the Fertiltech damage calculations, construction costs could be adjusted to account for potential cost overruns by relying on risk analyses conducted by internal technical and economic feasibility studies commissioned for the project (e.g., the technical feasibility study may contain an estimation of potential cost overruns) or by looking at industry studies. Similarly, the risk of construction and production delays could be accounted for by adjusting the timing of production and corresponding revenues (e.g., the same technical feasibility study may contain an estimation of potential construction delays). Consequently, the analysis of case- and industry-specific studies can provide robust sources to perform risk adjustments to account for uncertainty surrounding a project and provide the necessary degree of reasonable certainty with which damages can be awarded.

Conclusions

The rigid application of guidelines or reliance on previous tribunal awards can lead to the selection of a valuation method that does not fully reflect the value of the project or contract at issue in the case. Further, as demonstrated in the simple example of damages to Fertiltech, (1) there is no one-size-fits-all approach to determine the appropriate valuation method, and (2) the applicable valuation method is the one that best fits the facts, information and data for the case at hand.


Notes

[1] Santiago Dellepiane is a managing director, Andrea Cardani is a director and Julian Honowitz is a senior managing consultant at Berkeley Research Group. The authors thank Federico Sivak, associate at BRG, for his valuable contributions to this chapter.

[2] For example, if the claimant is entitled to be put back into the position as if an investment had never been made, the claimant may be entitled only to their investment value or sunk costs. If a claimant is entitled to be put back into the position it would have been in had the harmful act never occurred, they may be entitled to the fair market value of their investment. We note that lost profits’ analyses are also often undertaken in a manner consistent with the same guidance.

[3] Note, however, that best practice application of the income approach relies on use of market inputs where possible. For example, price forecasts may be best informed by commodity futures prices, cost projections by market forecasts, and even the discount rate should be anchored in market inputs.

[4] A Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (2nd ed., 2002), p. 11.

[5] A Damodaran, The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses (2nd ed., 2010), p. 1.

[6] id., at pp. 23 to 24.

[7] Specific variations to the income approach are applied in specific industries or circumstances, including adjusted present value and price to net asset value [P/NAV], among others. In gold mining valuation, for example, analysts evaluate the NAV of a company and compare it to a market price (either a company’s market cap or price per share). P/NAV is a hybrid approach that uses the income approach to determine the NAV of a company, and the market approach to evaluate a company against its peers using a standardised methodology to determine the P/NAV. The value of a firm is thus computed by multiplying its NAV by the P/NAV of its peer group. Comparing P/NAVs among a peer group can determine whether a company is overvalued or undervalued relative to similar firms.

[8] T Copeland, T Koller and J Mullin, Valuation: Measuring and Managing the Value of Companies (2nd ed., 1994), p. 70.

[9] Suez, Sociedad General de Aguas de Barcelona, S.A. and Vivendi Universal, S.A. v. Argentine Republic, ICSID Case No. ARB/03/19, ¶ 89.

[10] T Koller, M Goedhart and D Wessels, Valuation: Measuring and Managing the Value of Companies (6th ed., 2015), p. 331.

[11] Damodaran (2010) (footnote 5, above), at p. 90.

[12] For example, in the US beer distribution industry, the value of distribution rights is determined as a multiple of the distributor’s gross profits on the specific brand of beer in question.

[13] In the case of the public market, valuation experts generally assume that transactions of public company stock are sufficiently liquid as to represent a prorated portion of the intrinsic value of the company whose stock has been transacted. For private transactions, valuation experts generally assume that if a transaction is arm’s length, the acquirer has performed sufficient due diligence to determine the intrinsic value of the acquisition target. In both instances, market prices implicitly include forward-looking estimates of a company’s future prospects.

[14] Damodaran (2010) (footnote 5, above), at pp. 90 to 91. Adjustments for differences across assets also may include takeover or acquisition premia, or premia for control used to account for differences that arise owing to changes in the use of an asset, the owner of an asset, and the ability to transact an asset.

[15] OI European Group B.V. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB/11/25, ¶ 857.

[16] Crystallex International Corporation v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/11/2, ¶ 901.

[17] International Valuation Standards Council, Glossary, ¶ 5. See also S Pratt and A Niculita, Valuing a Business: The Analysis and Appraisal of Closely Held Companies (5th ed., 2008), ¶ 358.

[18] Pratt and Niculita (2008) (footnote 17, above), at ¶ 358.

[19] M Kantor, Valuation for Arbitration: Compensation Standards, Valuation Methods, and Expert Advice (2008), p. 12.

[20] Siemens A.G. v. The Argentine Republic, ICSID Case No. ARB/02/8, ¶ 355.

[21] In Asian Agricultural Products v. Sri Lanka, the tribunal considered the fair evaluation of compensation to be exclusively based on the tangible assets of the company in question. See Asian Agricultural Products Ltd. v. Republic of Sri Lanka, ICSID Case No. ARB/87/3, ¶ 100.

[22] Phillips Petroleum Company Iran v. The Islamic Republic of Iran, the National Iranian Oil Company, IUSCT Case No. 39, ¶ 115 (‘Another method which can help the Tribunal verify its findings . . . is to value the tangible investments made by the Claimant . . . as well as the Claimant’s intangible assets, including the profitability of its share of the going concern, and to deduct from these total assets the Claimant’s liabilities. [This method] puts more emphasis on actual investments and past performance as a basis for the assessment of expected profitability than on forecasts of expected cash flows’).

[23] World Bank, ‘Guidelines on the Treatment of Foreign Direct Investment’, Foreign Investment Law Journal, Chapter IV: Expropriation and Unilateral Alterations of Termination of Contracts (1992).

[24] id., at ¶ 6(i).

[25] id., at ¶ 6(ii).

[26] id., at ¶ 6(iii).

[27] I Marboe, Calculation of Compensation and Damages in International Investment Law, Oxford International Arbitration Series (2009), ¶ 4.35.

[28] The World Bank Guidelines define a ‘going concern’ as ‘an enterprise consisting of income-producing assets which has been in operation for a sufficient period of time to generate the data required for the calculation of future income and which could have been expected with reasonable certainty, if the taking had not occurred’. World Bank (1992), ¶ 6.

[29] We note that while easy to determine in this situation, it is rare to have publicly accessible and transparent data for identical comparable assets.

[30] This example is used for explanatory purposes only. Therefore, it includes generalisations and simplifying assumptions, and is not based on any real data, facts or cases.

[31] World Bank (1992) (footnote 24, above).

[32] id.

[33] As in the valuation of projects in operation, there are inputs to the cash flows projections that are inherently uncertain (for example, the cost of the chemicals to produce the fertiliser, local inflation, exchange rate fluctuations). As we explain below, the valuation exercise may require adjustments for risk and uncertainty either in the projection of the cash flow components or in the discount rate.

[34] A Damodaran, Corporate Finance Theory and Practice (2nd ed., John Wiley & Sons, Inc.) (2003), pp. 246 to 248.

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