There are many different valuation models that are used in court settings, and different techniques used by different experts can result in different valuations in various situations. For instance, one expert in a bankruptcy or an M&A case might use an income-based approach, while another might use a marketable value approach. It is important for attorneys to understand how to critique these methods in order to do an effective job for their clients.
There are three main methods used in valuing any asset in general: an approach based on the income (or synergies/savings) from an asset, an approach based on the fair market value an asset would fetch in an arm’s length transaction, and an approach based on the cost to replace or rebuild an asset.
The replacement or rebuild method is the easiest to critique and it is the least sound method of valuation. Many assets trade at values considerably different than their intrinsic values reflecting goodwill built up in businesses, value of intangibles like reputation, and the value of scarce resources (like geographic position) that may not be reflected in an accounting value. Thus replacement value methods are easy to critique since they don’t represent a fair or realistic view of any of the intangibles that are often associated with a business. Moreover, calculating replacement cost with any degree of accuracy can be very difficult since price quotes from suppliers are often distorted if an asset is being valued rather than an actual project being taken on.
Pursuing The Pro Bono Story: A Conversation With Alicia Aiken
This Pro Bono Week, get inspired to give back with PLI’s Pursuing Justice: The Pro Bono Files, a one-of-a-kind podcast hosted by Alicia Aiken.
The sales approach to valuation relies on coming up with an accurate estimate for what an asset would sell for in an arm’s length transaction. In theory, this is the fairest method of valuation since it is predicated on a willing buyer and seller. In practice, it often requires making some questionable assumptions which may not hold up to close scrutiny. For instance, sales approaches require finding comparable transactions that have occurred in the market. However, finding truly comparable sales is almost always difficult. Market conditions can change very quickly over time, and many assets have special features that either raise or lower their value considerably. Finally, the level of patience on the part of a buyer or seller is unobservable to outside parties, yet has a significant influence on sales values. All of these factors can make it challenging to defend a sales approach in court unless considerable time has been invested in addressing any potential complaint.
Perhaps the strongest method of valuation is based on the income or savings a potential asset generates. This is the method of valuation that is most consistent across a range of different industries such as equity valuation analysts, commercial real estate appraisers, private equity analysts, etc. Essentially, the method involves figuring out projected income from an asset in the future and then “discounting” that income to reflect its current value.
The income approach has two potential areas where it can be critiqued. First, forecasts of future income are difficult to create effectively. While past income levels give us some idea of what future income will be, even the largest and most stable of firms have consistent volatility in their income over time. Forecasting income for a firm effectively requires a statistical technique called multiple regression analysis. It’s a step that most valuation experts don’t take because it’s technically challenging. That is a mistake and it can open up questions about their forecast for future earnings.
Second, the income approach can be critiqued based on the rate used to discount future earnings back to the present. That discounting is supposed to reflect the level of risk for those cash flows, but in many cases, experts fail to justify that level of risk and the associated rate. This is a simple and effective technique for disqualifying a valuation. Using a higher rate, as associated with a riskier project, can lead to a much lower value for an asset.
Chrometa: Turning Time Into Billable Value For Modern Lawyers
Adoption of Chrometa represents more than a technological upgrade; it reflects a professional philosophy that values accuracy, transparency, and efficiency.
Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at [email protected].