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Discounted Cash Flawed

Is the DCF Model Subject to Manipulation?

The discounted cash flow analysis (“DCF”) has been a staple valuation and damages method for many years. However, a U.S. Bankruptcy Court recently suggested that the “striking” disparity between experts’ conclusions in a case before it, “lends credibility to the concept that the DCF method is subject to manipulation.” While it does not appear that the Court is suggesting that the DCF is an unacceptable valuation method, this case provides a meaningful lesson to valuation practitioners and damages experts that the support for key assumptions used in DCF calculations needs to be well grounded in the facts and economic reality of the case.

History of the Case

The case originated from the sale of a family-owned, men’s apparel business. Bachrach Clothing, Inc., was a retailer of men’s clothing and until 2005 was owned and operated by members of the founder’s family. In 2005, Sun Capital Partners purchased the business for $8 million; $4 million paid in cash and the other $4 million seller-financed on a subordinated basis.

Sun structured the sale as a leveraged buyout (“LBO”) by transferring the acquired stock to a related entity. The new entity then paid the sellers $4 million cash using a $2 million bank loan and a $2 million dividend. When the new entity issued the dividend, the board of directors concluded that the company was solvent. Sun’s advisors for the transaction, KPMG also concluded that the company was solvent.

Post-purchase, Sun appointed a new CEO, who lacked experience in the men’s retail space. The new CEO wrote down inventory, made significant personnel changes (including removing the former president), changed the website (reducing sales and profit margins) and reduced inventory orders for the holidays (depressing holiday sales). Throughout, the company continued to pay $400,000 a month in management fees to Sun. These factors caused a liquidity crunch and the company filed for bankruptcy protection in 2006.

The Claim

The debtors sued the former owners to recover the purchase price as a fraudulent conveyance; claiming that the company was insolvent at the time of sale.

Both the debtor and the former owners hired experts to value the company as of the date of sale and the LBO. Both experts relied upon a DCF approach but with significantly different outcomes. The debtor’s valuation expert concluded that the company was worth $1.1 million; however, after factoring in the management fee of $400,000 per month paid to Sun, the value was actually negative. On the other hand, the sellers’ expert believed the company was worth just over $6 million.

How did these two experts arrive at such different conclusions when they were valuing the same company using the same method? The reasons for the different results are grounded in the nature of the DCF model itself.

How the DCF Works

As its name suggests, the DCF method projects the future cash flows of the business and then discounts those cash flows to present value in order to arrive at the value of the business. The DCF is based on a series of inputs regarding the future of the business – its revenues, growth rate, expenses, profitability, capital expenditures, borrowings, etc. Even assuming that the same projections are used, two experts can reach different valuation conclusions because the valuation expert also must make decisions regarding the development of the discount rate (for example, the Weighted Average Cost of Capital [“WACC”] used in the Bachrach case).

In order to develop a WACC, the valuation expert must first determine the appropriate rates of return for both equity and debt and the appropriate proportions of debt and equity (the debt-to-equity ratio or capital structure) for the company being valued. The rates of return and capital structure are typically based on a combination of historical and industry data and company specific assessments. For some of these variables there are multiple potential sources of data that can be used to support assumptions. Once the capital structure and the equity and debt rates of return have been developed, the valuation expert can then calculate, for example, the WACC to be used as the discount rate.

Why the Experts Disagreed

The difference in the two Bachrach valuations was largely the result of different assumptions that the experts made regarding the following inputs into the WACC that was used in the DCF model:

  1. Debt-to-equity ratio or capital structure.
  2. Equity risk premium – A component of the equity rate of return.
  3. Size premium – Also a component of the equity rate of return.

Based on their respective assumptions regarding these elements, the debtor’s expert determined that the WACC was 19.5% and the sellers’ expert determined that the appropriate WACC was 12.3% (a lower discount rate results in a higher valuation and vice versa). In some instances, each expert cited the same study to support their fairly different conclusions.

The Court Rules

After hearing all of the evidence, the Court ruled against the debtor’s assertion of insolvency; concluding that there were “no facts or real world evidence” to support the claim that the company was insolvent at the time of the transactions in question (In re Bachrach Clothing, Inc., 2012 Bankr. LEXIS 4807 (Oct. 10, 2012)). Of more interest for the purposes of this article are the Court’s comments regarding the two expert’s opinions.

In a section of its opinion titled “Discounted Cash Flow Method vs. The Real World,” the Court was critical of the fact that the two experts — utilizing the same method — arrived at such different conclusions. This type of result “lends credibility to the concept that the DCF method is subject to manipulation and should be validated by other approaches.” The Court further stated that “each expert generally selected parameters that pushed his valuation in the direction he wanted to go.”

In the end, while stating that “neither expert’s approach was always consistent,” the Court found that the debtor’s expert “walked a thin line between expert and advocate,” failed to “explain the logic behind his choices” and “ignored actual market conditions.” In contrast, the seller’s expert “offered credible and convincing explanations of why he chose parameters;” therefore, the seller’s expert’s explanations for his choices were “better reasoned” and his opinion “was aligned with real world events or contemporaneous market data.”

Lessons for the Expert

The Bachrach Court appears to have been frustrated with the “striking” disparity in outcomes that resulted from the experts’ use of the DCF in this case. However, it does not appear that this opinion means the end of the DCF method, a method that relies on forward looking projections. The law requires a reasonable level of certainty and allows for the use of projections and assumptions as long as such projections and assumptions are not speculative.

As this case describes (consistent with recent damages cases in other areas), the valuation or damages expert should make every effort to provide “credible and convincing explanations” for why his or her assumptions are based on “real world events or contemporaneous market data.” In the absence of such a level of analysis by one (or both) experts in a case, significantly different DCF outcomes can result. However, if experts’ follow the Bachrach Court’s advice, the DCF model should provide reasonably consistent results regardless of the expert and will continue to be a valuable tool for the valuation profession and damages experts for years to come.

 

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Contact
  • Rebekah Smith
  • Director of Financial Advisory Services
  • (614) 947-5300
  • rsmith@gbq.com