The Applicable Valuation Approach

Introduction

Complex damages assessments often involve the valuation, at a specific point in time, of a financial asset or the economic rights to a stream of profits or cash flows. Valuation may also be directly relevant to a damages assessment if the claim relates to a diminution in the value of a tangible or intangible asset as a result of an alleged breach. Assessing the amount of damages that appropriately compensates the injured party for the loss of its ability or expectation to earn cash flows into the future, or for the diminution of value of its assets, can be a complex financial matter.

In this chapter, we discuss the fundamental drivers of value, describe the primary approaches and methods used to reflect those drivers to arrive at a value, and set out the key considerations in selecting an appropriate valuation approach or method.

Introduction to concept of value

Before turning to the primary approaches for valuing an asset, it is important to understand what we mean by ‘value’. In financial terms, the value of an asset is derived from its ability to generate benefits to its owner in the future. For a business investment, those ‘benefits’ are generally the cash flows that ownership of the investment is expected to generate. These can include the cash flows generated from the operation of the business, as well as any cash generated from the sale of its constituent assets.

The value is not simply a function of the amounts of these expected cash flows but also of their timing and the degree of uncertainty, or ‘risk’, attached to them. Consider two investments: investment A will yield $100 with certainty tomorrow and investment B will yield $100 with certainty in a year’s time. Investors will generally attach a lower value to investment B, mainly because receiving the money now from investment A would allow them to either spend it or invest it for a year and earn a return in that period. This is a concept referred to as the ‘time value of money’. Now consider investment C, which is also expected to yield $100 in a year’s time, but the precise amount it will yield is uncertain: with some probability it may yield less than $100 and with some probability it may yield more than $100 in a year’s time, such that the ‘expected value’ in statistical terms (i.e., the probability weighted set of all possible outcomes) is $100. Prudent (or risk-averse) investors would attach a lower value to investment C than to investment B, given the certainty of the latter.

Expectations as to the future benefits to be derived from an asset, the timing of those benefits and the risks associated with them are likely to evolve over time. Valuation, therefore, is not static and will typically vary over time as facts evolve and expectations as to the future change. For any valuation, therefore, a specific valuation date must be defined. It is a fundamental principle of valuation that only information that is known or knowable (i.e., could reasonably have been available to a prospective investor) as at the valuation date may be reflected in the valuation, although this is not always true for damages assessments. In a damages assessment context, the selection of the appropriate valuation date is a complex matter and may be informed by a number of factors, including the factual background to the dispute and legal arguments as to the appropriate basis of compensation. The most commonly used valuation dates tend to be the date of breach and the date of award. In dispute contexts, using information that became available only after the valuation date (i.e., using hindsight) may sometimes be acceptable.

Main valuation approaches

There are three primary approaches used to value an asset: the income approach, the market approach and the cost approach (sometimes referred to as the asset-based approach). Within each of these approaches, there are several possible methods for applying the approach. As already noted, the fundamental drivers of the value of an asset are the level, timing and riskiness of its expected cash flows. Under the income approach, these are explicitly estimated by the valuer. This approach, therefore, can be classified as an ‘explicit’ valuation approach. The market approach and the cost approach, by contrast, are ‘implicit’ approaches, whereby the fundamental drivers of value are not assessed explicitly but by reference to benchmarks that should implicitly reflect these drivers of value. In the case of the market approach, transaction prices are taken to reflect the views of the buyer (or buyers) and seller (or sellers) in that transaction as to the drivers of value for the asset in question. This transaction price, as discussed further below, may, then, be taken as a valuation benchmark. Under the cost approach, the cost incurred to purchase or construct the asset is taken as a valuation benchmark. Regardless of whether the fundamental drivers of the asset or company value are set out explicitly under the income approach, or implicitly under the market approach or cost approach, it is important to understand that each of these approaches is ultimately seeking to value the same thing. Which of the approaches is most appropriate in any given case is dependent on a number of factors, including the quality of information available, the strengths and weaknesses of the respective approaches and the nature of the asset, as explained further below.[2]

Income approach

The income approach is commonly used, both in disputes and in other contexts, such as transactions. Although a number of different methods are used to implement the income approach, as the International Valuation Standards Council notes in its International Valuation Standards (IVS), they are all variations of the discounted cash flow (DCF) method, and involve the application of the same concepts.[3] The DCF method involves forecasting cash flows over a certain period (the explicit forecast period) and discounting these at a rate that reflects the time value of money and the level of risk attached to these cash flows, so as to derive their net present value. Any value of the assets beyond the explicit forecast period is reflected through the inclusion of a ‘terminal value’ at the end of that period.

Figure 1: Illustrative example DCF calculation

Example: DCF calculation for an asset with expected cash flows of $100 paid at the end of each year over a five-year forecast period, and with a terminal value of $400 as at the end of the five-year period, discounted at a rate of 10 per cent. The shaded areas show the undiscounted cash flows and the solid areas the discounted cash flows.

The reliable application of this approach depends, therefore, on the ability to reliably forecast cash flows over a number of years and to estimate a reasonable discount rate. Typically, a DCF valuation can be highly sensitive to changes in each of these two components.

The construction of cash flow forecasts typically involves making certain assumptions, or judgements, as to the key inputs to the future level of cash that is generated – be it the future price at which the good is sold, the volume of sales, the appropriate level of costs and, therefore, of margins, the amount of investment required to achieve the projected sales, and so on. For the DCF valuation to be reliable, it is important to have a reliable basis for the selection of these inputs. This means that the quality and availability of relevant information is crucial. This is often interpreted to mean that a DCF is only reliable where there is an established track record of profitability for the business in question. However, this is not necessarily the case. Ultimately, future operating performance is what drives future cash flow forecasts, and although historical operating performance may be a useful indicator of, or cross-check to, future expected performance, other information may also be useful. For example, an oil producer at the point of the first production of oil will have no historical profits but its future profits may be derived reliably from well-established, proved reserves, which will be sold at well-published spot and future/forward prices and for which there are also numerous available third-party forecasts – in this case one would not necessarily conclude that there is no reliable basis for forecasting future performance.

The discount rate used to convert a stream of future cash flows into a present value should account for the time value of money and the risk attached to these cash flows. The methods most commonly used to estimate the discount rates are covered in other chapters of this book. All else being equal, the sensitivity of a DCF valuation to the selection of the discount rate is higher if a large proportion of the asset’s cash flows is expected to be generated further into the future, as compared with cases in which a large proportion of the asset’s cash flows is expected in the short term.

Market approach

The market approach is a relative valuation approach whereby the value of an asset or business is assessed by reference to the prices paid for comparable assets or businesses. Under this approach, valuation is conducted by comparison ‘with identical or comparable (that is similar) assets for which price information is available’.[4] This price information includes:

  • the price at which transactions for comparable companies have taken place (sometimes referred to as the comparable transactions method); or
  • the price at which shares in comparable companies are publicly traded (sometimes referred to as the guideline publicly traded comparable method).

The application of both methods requires the identification of companies that are sufficiently comparable such that this price information provides a reliable benchmark for the valuation of the asset being valued. As explained above, the fundamental drivers of value are the future cash flow trajectory (i.e., both the level and the timing of cash flows) and their risk. Therefore, to identify comparable companies, it is necessary to identify companies with similar cash flow growth profiles and levels of perceived risk to the company being valued.

Generally, the single most relevant comparable company will be the company itself, and where information as to the prices paid in prior transactions or the listed share price of the company is available, this will often provide a useful valuation benchmark – albeit care must be taken to check whether the company’s economic prospects have materially changed between the date of the prior transaction and the valuation date, or whether the prior transaction occurred under any circumstances that limit its use as a valuation benchmark, for example, if it was not conducted on arm’s length terms.

Where other comparable companies are selected, in practice valuers typically select companies that are similar to the company being valued in terms of having similar business operations, the assumption being that this means the subject company and the comparable companies are expected to experience similar growth in profitability at similar risks.[5] This similarity can be assessed by considering a number of factors, such as market segment, product mix, geography, size, growth rates, and so on. Because these companies may be of a different scale from the company being valued, valuers often rely on their relative value, rather than absolute value, as a benchmark. This is typically done by reference to valuation multiples, whereby the enterprise value (EV) or equity value of the comparable company is scaled by dividing it by an operating metric (e.g., number of rooms for a hotel) or a financial metric (e.g., an earnings measure such as EBITDA (earnings before interest, tax, depreciation and amortisation)), either using historical measures (sometimes referred to as ‘trailing’ multiples), current year measures that may reflect a combination of actual and forecast budgeted results for the remainder of the year (‘current’ multiples) or forecast measures for future years (‘forward’ multiples). When the comparable transactions method is used, it results in applying ‘transaction multiples’ and when the guideline publicly traded comparable method is used, it results in applying ‘trading multiples’.

The most commonly used multiples and the bases for their selection are covered in other chapters of this book.

Cost approach

The IVS state:

The cost approach provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction, unless undue time, inconvenience, risk or other factors are involved. The approach provides an indication of value by calculating the current replacement or reproduction cost of an asset and making deductions for physical deterioration and all other relevant forms of obsolescence.[6]

The cost approach may be applicable when it is reasonably feasible to recreate a business with similar utility as the business being valued by purchase or construction of its constituent assets. This is the case when:

  • the value of the business can be fully or mainly attributed to its identifiable tangible and intangible assets;
  • information as to the cost to purchase or construct those assets is readily available; and
  • the costs of purchase or construction reflect the value to the business of those assets.

This will be the case for a business that is no longer a going concern, whose future cash flows will be obtained via a liquidation of its assets. This may also be the case for certain businesses, such as banks, whose assets are regularly marked-to-market, or property holding companies, whose portfolio is regularly valued. However, for many going concern businesses, significant value is derived from intangible assets such as brand value, customer relationships and goodwill in the broader sense of the word (i.e., the benefits of combining the different assets of the company such that the value of the whole is greater than the sum of the parts). These assets are difficult to identify, and it is difficult to estimate a replacement or reproduction cost for them. For this type of business, cost approach methods are likely to be less applicable, except as a floor value or as a cross-check.

It is important to note that the cost approach does not involve taking the historical or investment costs of the assets (i.e., the sunk costs) but may involve starting with historical costs less depreciation, to the extent that historical costs are a reasonable proxy for current value.

Summary of valuation approaches

The key features of the three main valuation approaches are summarised in the table below, in relation to the valuation of a company.

Valuation approachKey features
Income approachInvolves forecasting future cash flows to be derived from the subject company and discounting them at a discount rate that reflects the time value of money and the risks attached to the forecasts to arrive at a present value as at the valuation date
Market approachRelative valuation approach. Involves valuing the subject company by applying the trading or transaction multiples of comparable companies (at or around the valuation date) to the corresponding metric of the subject company
Cost approachInvolves valuing the subject company by adding the replacement or reproduction cost of the assets on its balance sheet and deducting the value of its liabilities. Typically excludes the value of goodwill and other intangible assets not recognised on the subject company’s balance sheet

Summary of strengths and weaknesses of main valuation approaches

Each valuation approach has certain strengths and weaknesses, as summarised in the table below.

Valuation approachStrengthsWeaknesses
Income approachFlexible – can be applied to value different types of assets, including those with a finite lifespan

Transparent – assumptions are set out explicitly so they can each be adjusted and the effects of these adjustments on value can be clearly measured

Often used in the context of transactions and by equity analysts

Can be complicated or onerous (or both) to prepare and check. Requires reliable multi-year cash flow forecasts prepared around the valuation date

Requires a solid basis for estimating the discount rate, e.g., comparable traded companies (see below)

Risk of garbage in garbage out (GIGO) for many of the assumptions used in forecasting future cash flows or estimating the discount rate

Market approachBased on prices paid in actual transactions by (presumably) knowledgeable market players

Can be simpler and quicker to apply than income approach because it does not require as much information

In principle, it uses three components:

1) the numerator (EV or equity value) of the comparable companies;

2) the denominator (e.g., EBITDA) for the comparable companies; and

3) the corresponding denominator for the subject company

Often used in the context of transactions and by equity analysts

Requires sufficiently comparable companies being publicly traded or having been acquired around the valuation date

The analysis of each of the three components of a multiple may involve significant complexity, such that what may appear to be a simple calculation can in fact require significant time and effort to produce

Risk of GIGO concentrated on the three components used, so the effects on value of any of the three components being incorrect is high

Cost approachCan also be quicker to apply than the income approach, although it does require an analysis of all the assets and liabilities on the balance sheet of a company

May be appealing as the basis for damages if a tribunal is not satisfied that the company has any value in excess of the sum of the value of the constituent assets

Can be appropriate if a liquidation of the business is expected

Likely to reflect a floor value because it excludes the value of goodwill and intangible assets not on the balance sheet, so does not reflect the potential of the combination of assets to add value in the future

For a company, assets and liabilities can be difficult to value (see weaknesses of the two approaches above), so valuers often assume the book value of the assets and liabilities (i.e., their purchase costs less accounting depreciation) reflects their market value, which is not often the case

Selecting the appropriate valuation approach or approaches

The nature of the company or asset being valued and the quantity and quality of available information will determine which approach is feasible, and which approach or approaches may be preferable in any given case. The decision as to how much weight to put on the income approach value will depend largely on the availability of sufficient information to construct well-supported cash flow forecasts, whereas the decision as to how much weight to put on the market approach will depend on the availability of market transactions involving companies or assets that are sufficiently comparable to the subject company or asset. The decision to apply the cost approach is more a function of the nature of the business being valued and the circumstances in which the valuation is required, with the cost approach being more suited to businesses for which the value of goodwill (in the wider sense of the word) is expected to be low.

It is not reasonable to generalise or apply any rules rigidly without proper consideration of the specifics of each case. The IVS recommend considering more than one valuation approach if and wherever possible:

Valuers are not required to use more than one method for the valuation of an asset, particularly when the valuer has a high degree of confidence in the accuracy and reliability of a single method, given the facts and circumstances of the valuation engagement. However, valuers should consider the use of multiple approaches and methods and more than one valuation approach or method should be considered and may be used to arrive at an indication of value, particularly when there are insufficient factual or observable inputs for a single method to produce a reliable conclusion.[7]

We would recommend considering as many valuation approaches as is reasonably feasible in the situation at hand, given the practical limitations in terms of information, time and budget. If the income approach is used, then a substantial part of the information required to use the market approach is likely to have already been collected, and thus the incremental time and cost of applying the market approach are likely to be limited.

If one valuation approach is particularly suited to the situation, we would consider using another valuation approach only as a cross-check of the value derived from the main valuation approach. For example, the valuation of a discrete cash flow stream over a finite period may require the use of the income approach, as those specific cash flows can be explicitly reflected, whereas the market approach is likely to be less suitable if the available price information relates to transactions in comparable companies or assets that are expected to continue operating for the foreseeable future or for a different period from that of the subject asset. In such a case, the market approach may nevertheless provide a sense check – for example, an implied multiple from the DCF valuation that is significantly higher than the multiples observed for large listed comparable companies would require checks and explanations.

If there are issues with all the valuation approaches, such that none is clearly preferable, we would consider using several valuation approaches, and within each valuation approach, more than one valuation method. We would then triangulate and rationalise the different values obtained. For example, we might consider using both the comparable transactions method and the guideline publicly traded comparable method within the market approach, and consider using a DCF arriving at an enterprise value and a DCF arriving at an equity value.

For each application of a valuation method, it may also be appropriate to consider a range of values, reflecting a reasonable range of key valuation inputs, such as a range of discount rates in a DCF valuation or a range of multiples within a comparable transactions method. An example of a resulting set of valuation ranges is shown in Figure 2, below.

Figure 2: Illustrative summary of valuation ranges obtained using different methods

To arrive at a final opinion on value, a number of options could be used, after the differences between the values obtained have been rationalised and the valuations or assumptions have been adjusted, if needed:

  • select the simple average of the values obtained from the different valuation methods or approaches;
  • select a weighted average of the values obtained from the different valuation methods or approaches, with different weights being given to the values obtained from those methods or approaches. There are no general rules as to what weights to place on the different valuation outputs. Rather, this is an area for reasoned judgement and therefore, for controversy and differences of opinion between valuers; and
  • select the value derived from a preferred valuation approach or method, having checked that this value is not an outlier compared with the values obtained from the other valuation methods or approaches. For example, this could be done by selecting the top end of the DCF value range, which would be consistent with the value ranges obtained in most of the other methods (see the vertical line in Figure 2, above).

Valuation approaches and damages assessment bases used in disputes

Data on parties’ and tribunals’ preferred valuation approaches is limited, particularly in commercial arbitration. A 2020 Queen Mary University of London study of International Chamber of Commerce awards found that sunk costs was proposed by claimants as the basis for claims in 63 per cent of cases, the income approach in 29 per cent of cases and the market approach in only 5 per cent of cases.[8] A study of investment treaty awards published by PwC in 2017 showed that the income approach was proposed by claimants in 51 per cent of cases, with sunk costs being preferred in 14 per cent of cases and the market approach in 6 per cent of cases.[9] The PwC research also shows that the DCF method was the method most commonly preferred by tribunals (in about 45 per cent of cases), with historical cost or investment cost (i.e., sunk costs) being preferred in about 35 per cent of cases and the market approach in about 10 per cent of cases.[10] It is important to remember that taking sunk costs is not a valuation approach but an alternative damages assessment basis.

Summary

We have described the fundamental drivers of the value of economic assets and explained the main features, strengths and weaknesses of the main approaches used to value assets. Although the appropriateness and application of each of these valuation approaches are complex matters, we have set out the key considerations that are likely to be relevant to their applicability in the assessment of damages. There are no general rules as to the applicability of a valuation approach by reference to the nature of the asset or company to be valued or the nature of the dispute. Therefore, considering all available valuation approaches would be a good place to start.


Notes

[1] Roula Harfouche is a partner and Joseph Kirby is an associate director at HKA. The authors wish to thank Jana Lefranc and Colin Johnson for their comments on this chapter.

[2] Aswath Damodaran, ‘Damodaran on Valuation – Security Analysis for Investment and Corporate Finance’ (2nd edition), page 245.

[3] International Valuation Standards (IVS), 105 2022: 50.1.

[4] IVS 105 2022: 20.1.

[5] Aswath Damodaran, Damodaran on Valuation: Security Analysis for Investment and Corporate Finance (2nd edition, 2006), page 245.

[6] IVS 105 2022: 60.1.

[7] IVS 105 2022: 10.4.

[8] Queen Mary University of London study, page 14 – search for ‘RITM3762683_Queen Mary research paper_IR_V04.indd’ at qmul.ac.uk (last accessed 26 September 2022).

[9] id.

[10] ‘PwC International Arbitration damages research: 2017 update’, page 6, available at pwc-international-arbitration-damages-research-2017.pdf (last accessed 26 September 2022).

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