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June 1, 2011

The causes of commercial damages are many, and loss estimates can vary considerably between experts. Whether it involves contract disputes, fraud and unfair competition, or negligence claims that cause significant profit loss, extensive damage analysis is necessary to determine an appropriate method for a company to recover such losses.

These damages are most often measured by lost profits; however, in certain cases, it is appropriate to apply business valuation approaches in estimating damages. This may include circumstances where the breach results in the total loss of a business (or an income-producing asset) or in a permanent loss of value to the business. In these instances, an expert must consider the valuation approach that would be most appropriate, and compare the value of the business (including damages) to the actual value of the business to determine the loss suffered. In some cases, an adjustment must be made for mitigation opportunities available to the damaged party.

Business Valuation Approaches
There are three generally accepted approaches used in business valuation: the asset-based, market and income approaches.

Asset-Based Approach
This involves analyzing a company’s tangible and intangible assets net of liabilities to determine its value. However, it does not address the operating earnings of the business, which is a necessary component in calculating an enterprise’s value. As a result, this approach is not often used to determine the value of an operating business, although it can be useful in establishing the value of specific assets. The asset-based approach is most useful in estimating the value of a non-operating business where cash flows are nominal, such as a holding company or a business that consistently generates losses. It is also used in situations where liquidation is imminent.

Market Approach
Sometimes referred to as “relative valuation,” this approach is based on the idea that the value of a business can be determined through a comparison to similar companies for which transaction values are known. It relies on the concept that buyers will not pay more than, and the sellers will not accept less than, the price of a comparable business enterprise. The approach uses pricing multiples taken from these comparable companies or transactions and applies them to the appropriate performance measure of the company being valued. These multiples establish a relationship between the business’s economic performance, such as its revenues or profits, and its potential selling price.

The challenge in using this approach occurs when only limited comparable company data can be identified. It can also be difficult to adjust the data to include the unique operating characteristics of the subject firm in the determination of its value. Finally, while the market approach is widely used in practice, and can provide a useful indication of value, in litigation, the assumptions required in its application often face effective challenges.

Income Approach
This approach values a company based on its earning capacity. The two basic methods are: (1) single period capitalization, which is most appropriately used when current earnings are believed to represent the future operations and the company is expected to have modest, stable growth, and (2) multiple period discounting, or the discounted future earnings method, which allows for changes to business growth rates and profit margins.

The income approach calculates a company’s value by applying a discount or capitalization rate to a measure of its expected future earnings to arrive at a present value of these future benefit streams. It requires the valuator to analyze the company’s earnings prospects and the risks associated with achieving those future prospects through the determination of discount or capitalization rates. This also requires an in-depth understanding of the fundamental factors driving the value of the business.

A key difference between (1) a typical lost profits analysis using the principles of the income approach and (2) a business valuation approach to damages using this approach involves the application of a terminal value, which is calculated based on the assumption that the business has an indefinite life. This approach is commonly used in estimating the value of both publicly traded and closely held businesses, as well as in calculating certain types of commercial damages.

Valuation Approaches in Commercial Damages Litigation
In a commercial damages case, a claim is made for a loss of earnings due to some form of “complained-of” acts. If that loss is considered permanent, a valuation approach to damages may be appropriate. Because the asset-based valuation approach does not focus on the subject entity’s income stream, it is not useful in determining these types of damages, although it can be useful, in conjunction with a discounted future earnings method, in establishing the value of specific assets.

The market approach, generally more useful in evaluating public companies than those privately held, allows limited flexibility to incorporate the unique operating characteristics of the company being valued against the comparable firm's. When sufficient data is available, it is often used to support a valuation conclusion reached through other approaches.

The income approach considers the qualitative characteristics of the subject company, generally making it a more tailored and useful approach in damages claims. Furthermore, in estimating future income streams, the valuator has the ability to analyze the subject entity’s future earnings, taking into account instances where those earnings may reflect the company’s ability to recover some of the losses it claims to have incurred and to mitigate those losses, for example, through expense reductions or an increased focus on generating revenue from alternative sources.

It is no coincidence that most commercial damages claims rely on calculating lost profits, often relying on the principles underlying the income approach to valuation. Estimating lost profits requires analysis of the same drivers of profitability analyzed in the income approach  future earnings and the risks associated with achievement of these earnings.