Some bloggers have said that the U.S. Bankruptcy Court has “discredited” the discounted cash flow method of valuation in the case of In re Bachrach Clothing, Inc. (Bankruptcy No. 06-06525, Adversary No. 08-00726, in the U.S. Bankruptcy Court for the Northern District of Illinois, Eastern Div.)
That’s an unnerving conclusion for those who find many practical applications for its use. But a review of the 86-page Memorandum Opinion issued Oct. 10, 2012, allows room for a different conclusion.
The Discounted Cash Flow Method
The court defined discounted cash flow method (DCF) as“the value of a company derived from the present value of expected cash flows, taking into account appropriate risk. … The cash flows are made up of two periods: the discrete period, which is usually projected cash flows over four or five years, and the terminal period, which starts after the discrete period and attempts to reflect the future cash flows of the company. These cash flows are summed and discounted to their present value.”
Bachrach Clothing, Inc., a men’s clothing enterprise that had been profitable for a century, sold its interest to Sun Investment Partners in a leveraged buyout. Sun bought Bachrach for $8 million, paying $4 million in cash and financing the remaining $4 million. Auditors opined that Sun’s purchase price was “substantially less than the book value of [Bachrach].”
After the sale, Sun’s people were placed in charge even though they had no experience in men’s clothing sales. The owners and managers of Bachrach were not retained to assist. Bachrach had always operated on a cash basis, but Sun did not. In fact, Sun siphoned off $2 million of cash immediately after the sale and paid it out as dividends to its partners.
It then dramatically discounted inventory to generate quick cash inflows, alleging that Bachrach routinely held obsolete inventory for years, even though the inventory consisted mainly of items less than one year old.
Both experts used DCF in formulating their opinions of Bachrach’s value. The problem lies in their different approaches to evaluating the variables.
The Bankruptcy Court said that, “Although both [experts] used Sun’s projections of [Bachrach’s] cash flows, the disparity in their valuations is striking given that they relied on the same data as their starting point. It lends credibility to the concept that the DCF method is subject to manipulation and should be validated by other approaches.”
Both experts were inconsistent at trial. Bachrach’s valuation was “better reasoned” and “aligned with … ‘contemporaneous market data.’” Sun’s opinion “stands alone” as “wholly unsupported except for selected statistical tables … [which] also support [Bachrach]. When apportioning debt and equity, Sun’s expert “did not back up his claim with any literature and his critique was not explained enough to make sense.”
Both parties overstated equity risk premium, misunderstanding the method advocated in the supporting treatise they both used. Sun’s expert failed to use his empirical observations about company size premiums to inform his analysis. These factors threw off the experts’ weighted average cost of capital analysis. Most important, the court saw Sun’s expert “continued his approach of shuffling numbers in and out of formulas to get where he needed to go.”
The Preferred Method?
Conceptually, DCF is easily understood and explained, though details of a valuation might be challenging. Every accountant studies DCF in business school, and others can relate to it conceptually based on grade-school studies of comparing fractions by reducing them to their lowest common denominators. As long as the assumptions are correct, DCF will continue to be a useful tool, especially in smaller cases where complicated valuation methods aren’t cost-beneficial.
Consider the New York Supreme Court case of Hunts Point Terminal Produce Coop. Ass’n., Inc. v. Harlem River Yard Ventures, Inc. (2011). Harlem’s majority shareholder elected to merge Harlem into a new S corporation.
Hunts Point, the minority shareholder, could not be an S-corp shareholder and was forced to take cash for its shares. It sued to determine the fair value of its shares. The judge found that DCF was “the preferable method” compared to the capitalization of income method based on facts peculiar to the case.
Importantly, the court was active in defining certain variables based on evidence, such as the marketability discount and discount rate of return; agreement by the parties to certain variables and assumptions; and finding that mathematical calculations were not in dispute.
The Hunts Point court recognized that “valuing a closely held corporation is not an exact science” and proactively minimized disputes about variables before applying DCF. The Bachrach court did not reject DCF. It rejected the credibility of Sun’s expert on his DCF assumptions and calculations.
The court said the discounted cash flow method should be supported by a reality check – some other method to show that the expert’s conclusion makes sense. When possible, conducting a reality check can be helpful anyway, regardless of the method of valuation used.
In the end, the Bachrach opinion is not so much about DCF as a valuation model as it is about the more pervasive issue of witness credibility. It stands for the proposition that experts should be prepared to back up their data, calculations and opinions with real-world information so the courts can use their expert opinions with confidence.