Hello, my name is Richard Claywell and this is litigation speaks.  When reviewing business valuation reports I have seen cases where the opposing expert will capitalize pre-tax earnings and then apply an after-tax cash flow discount/capitalization rate to the earnings.

Depending on the experience level of the expert, they may not notice this potential error and this could result in a significant difference in value that could be detrimental to your client at settlement conferences or at trial.

Discount/Capitalization Rate is After Tax Cash Flows

It is not unusual to see a business valuation expert use a capitalization methodology and capitalize the pre-tax earnings by using an after-tax rate.  Using a pre-tax earnings and an after-tax cash flow rate is wrong and is not supported an any of the business valuation treatises.

This is a beginner’s mistake and will always produce an incorrect value.

If a capitalization methodology is used in a business valuation, it should raise a huge red flag for attorneys as to its appropriateness.  When the earnings methodology is used, it does not take into consideration the adjustments needed to convert the net income (earnings) to cash flows.

Net Income /Earnings Should Be Adjusted To Cash Flows

The cash flow discount/capitalization rate reflects the adjustment from net income (earnings) to cash flows).  Using the net cash flow rate with net income/earnings is like mixing water and oil.  They just do not mix.  Within the business valuation process the net income/earnings should be adjusted for noncash charges, capital expenditures and changes in net working capital.  If the business valuation expert is using the equity method for valuing a company, they typically ignore or state a reason that the changes in long-term debt are immaterial.  The changes in long-term debt can have a significant impact on the businesses value.

If these adjustments are not made, the expert is not appropriately determining the value of a business.

Table of Cash Flow Discount Rates

The following table indicates the process of adjusting net income (earnings) to cash flows.  The Net Cash Flow to Equity and Net Cash Flow to Invested Capital are calculated differently but the same issue exists when not making the adjustments from net income (earnings) to cash flows.

Table of Cash Flow Discount Rates

Business Valuation: Not Converting Net Income to Cash Flows Deposition or Trial Questions for Attorneys

These apply if the expert used a capitalization or discounting of net income or earnings.

Question: Verify that the expert has used the correct capitalization rate methodology.

Answer: Should be yes.

Question: Ask the expert the treatise used for making the calculation.

Answer: None it does not exist

Question: Ask the expert if there is another way to determine the discount/capitalization rate

Answer: Probably NO. They do not understand a basis premise of business valuations.