Revisiting Modeling
For Calculating Future Lost Profits
Robert Dunn and Everett Harry published their oft cited Modeling and Discounting Future Damages in 2002. The article laid out the process for assessing future lost profits and discounting them to present value. They argued modeling future losses reduced the uncertainty related to the loss calculation and therefore reduced the risk premium to be included in the discount rate. They also argued modeling future losses and using a risk-reduced, relatively low discount rate was easier for judges and juries to understand. While their discussion on a risk-adjusted discount rate has been somewhat controversial, the need for reviewing a plaintiff’s projections and adjusting them for various factors is not. In this article, the need for modeling is revisited showing not only Dunn and Harry but Federal Circuit Courts of Appeal also believe modeling is appropriate when analyzing future lost profits.
[su_pullquote align=”right”]Resources:
10 Common Errors in Lost Profits Calculations and Business Damages
Elements of Lost Profits and Introduction to Lost Profits
Other Considerations in Lost Profits Calculations
Commercial Damages and Lost Profits
[/su_pullquote]
Robert Dunn and Everett Harry published Modeling and Discounting Future Damages in 2002.[1] The article laid out the process for assessing future lost profits and discounting them to present value. They argued modeling future losses reduced the uncertainty related to the loss calculation and therefore reduced the risk premium to be included in the discount rate. While their discussion on a risk-adjusted discount rate has been somewhat controversial, the need for reviewing a plaintiff’s projections and adjusting them for various factors is not. In this article, the need for modeling is revisited. In a later article, the controversy over the appropriate discount rate will be discussed.
Analyzing future lost profits is a two-step process. The first step projects the plaintiff’s lost income stream. This includes estimating revenue, saved expenses, and the resulting lost profits. The second step calls for determining the appropriate discount rate to be applied to the future losses and discounting those losses to present value. Dunn and Harry argued the methodology used in step one for determining future losses will impact the discount rate used in step two. They write:
Some CPA experts project the plaintiff’s hoped-for income stream, modify those losses to a realistic expectation by factoring in future risks, and then discounting the adjusted future losses to a present value at a risk-reduced, relatively low rate. Other experts project the hoped-for-but-lost amounts and then apply a higher discount rate that already incorporates risk or uncertainty to determine the present value.[2]
Dunn and Harry felt the first approach—modeling the future losses—and then using a risk-reduced, relatively low discount rate, was easier for judges and juries to understand. This position has been rejected over the past few years by many experts who have focused on applying a higher discount rate based on some form of weighted average cost of capital (WACC). Harry believes this is because of the “growing number of professionals…attaining business valuation accreditations and applying the related body of knowledge for free market asset valuations to litigation damages computation assignments.”[3]
This focus on risk premiums and discount rates has even become a problem in the valuation field. Professor Aswath Damodaran of New York University’s Stern School of Business recently noted, “When your valuations go awry, it is almost never because of the mistakes you made on the discount rate and almost always because of errors in your estimates of cash flow (with growth, margins, and reinvestment). Therefore, you should focus on making the most accurate cash flow projections possible and include all risks, instead of ‘obsessing about the minutiae of discount rates.’”[4]
Although Dr. Damodaran was discussing the techniques for valuing a business, the thrust of his opinion applies to calculating lost profits as well. His comments highlight the importance of modeling plaintiff’s projections when assessing a plaintiff’s lost profits.
Methods for Estimating Lost Profits
On accepting an assignment, an expert’s primary goal should be to generate an unbiased report that is acceptable to the court. “For their opinions to be admissible, damages experts must…ensure that their lost profits opinions are based on reliable evidence and are free of unwarranted speculation. To accomplish this, they must have comprehensive knowledge of the business…and its products, operations, and competitors, as well as a complete understanding of the relevant industry. Further, such an analysis should be amply supported by relevant and reliable evidence.”[5]
Not all methods used in calculating lost profits call for modeling. This section reviews the three most commonly used methods and discusses whether modeling is appropriate for each one. The three most commonly used methods are before and after, yardstick, and but for. The facts of each specific case will determine the method to be used for calculating lost profits.
The Before and After Method—The expert simply compares the plaintiff’s revenues before the alleged breach or tort to the revenues after the event. Any reduction in revenues after the alleged breach or tort is presumed to be caused by the event.
“This method compares the revenue and profits before and after an event…A diminution in revenues or profits may be established based on the difference between the before and after levels. This method assumes that the past performance of the plaintiff is representative of its performance over the loss period. It also assumes that sufficient historical data are available from which to construct a statistically reliable forecast. In addition, it assumes that economic and industry conditions during the loss period are similar to what they were during the before period so that the data are comparable.”[6]
Modeling is not used when applying this method. This is because economic and industry conditions are assumed to remain unchanged during the loss period and that the company would have performed just as it had in the past if not for the wrongful act of the defendant.
The Yardstick Method—This method compares the plaintiff’s earnings against those of a similar business, product, or other comparable measure. Sources such as industry trade organizations, RMA, Business Valuation Resources (BVR), and the Internal Revenue Service Corporate Statistics may provide statistics to be used as the comparable data.
Again, modeling is not used with the application of this method. The plaintiff’s revenues and profits are compared with similar businesses or industrial statistics. The difference between the statistical revenue and profit figures and the plaintiff’s figures are assumed to be lost profits.
The But For Method—The first two methods provide for a fairly straightforward analysis. In a complex situation, these approaches may fail to consider other factors that would tend to increase or decrease the plaintiff’s revenue and related lost profits. Ideally, a comprehensive but for analysis will consider all potential factors working in concert with each other that affect the plaintiff’s earnings during the period under consideration and will, in turn, segregate those which were caused by the defendant from those which were not. The interrelationship of those factors will generally make this process difficult to execute with precision. In complex matters, with significant revenues, it may be appropriate to evaluate the use of techniques such as the Monte Carlo simulation method or the use of marketing experts.[7]
It is in the preparation of a but for report where experts use modeling. It is through this process an expert’s report may be constructed to provide the relevant and reliable assessment of lost profits that is expected by the court. “The but for projection…will likely be challenged by opposing counsel and witnesses. For example, defense counsel may argue that plaintiff’s alleged…lost profits damages is based upon overly optimistic and unattainable premises in the but for world.”[8] To protect against such claims, an expert uses modeling to adjust for various factors and market conditions impacting the plaintiff’s lost profits.
What is Modeling?
Modeling is “examining the interactive components of a financial outcome and analyzing various input factors.”[9] The expert’s lost profits model will be “based on a prediction of lost net sales less their saved costs such as variable production and business expenses. For the overall period between the lost net revenue and the expenses saved (variable business costs) represents the plaintiff’s lost profits had the damage not occurred.”[10]
For creating this model, an expert will rely on the plaintiff’s records to project its anticipated financial performance had the alleged wrongful act not occurred. The expert should consider how detailed the model should be. “Should projecting the income statement be done in a relatively simple, straightforward way, or should a number of different assumptions…be driving it?”[11]
To get started, an expert will ask for a series of financial records. Records requested may include prior financial statements, business tax returns, internal budgets, and projections created for internal use or to be provided to investors or lenders reflecting the anticipated profits during the loss period. In addition, interviews with persons knowledgeable of the business, industry, and/or transactions involved in the litigation may also provide helpful information.
“In considering these sources of information, it should be determined whether they are unduly optimistic or pessimistic, and if they are, that fact should be taken into account when preparing financial forecasts.”[12]
Even if a review of the provided data shows the future projections to be consistent with prior performance, the cash flows still contain a level of uncertainty. “The cash flows themselves usually come from management’s estimates of the firm’s future performance. As such, they are necessarily subject to uncertainty relating to matters specific to the firm as well as to broader issues, such as the general state of the economy, advances in technology, effectiveness of management, labor issues, actions of competitors, price of raw material, etc.”[13]
Because of this uncertainty, an expert should not accept the plaintiff’s projections at face value. Adjustments should be made to compensate for actions other than those brought about by the alleged wrongful act.
In Adelphia Recovery Trust v. FPL Group, management projections were found to be unreliable by the court due to fraud. The judge noted, “As a matter of common sense, DCF [discounted cash flow] works best (and arguably, only) [i] when a company has accurate projections of future cash flows, [ii] when projections are not tainted by fraud, and [iii] when at least some of the cash flows are positive.”[14]
While this may be an extreme example for not relying on management projections, it underlines the need for an expert to examine, analyze, and adjust (when needed) projections in estimating lost profits.
Considering External Factors
Some factors natural to the lawsuit benefit the expert and provide support when modeling lost profits. In any litigation, the plaintiff will claim a loss period. This period will run from the date of the alleged wrongful act for some period of time, weeks, months, or years. Because of being hired after the start of the loss period, an expert will have the advantage of hindsight, for at least a portion of the loss period, when assessing the plaintiff’s assumptions regarding performance of the overall economy, its competition, and perhaps the market it was serving. In addition, any changes in technology and/or regulation affecting the plaintiff’s business or markets served will be known.
“[S]ubstantial case law indicates that experts can, and indeed should, incorporate all information, even information relating to events that occurred after the date of damage or after the date of hypothetical negotiation in the damages analysis.”[15]
Opinions from the Fifth and Eighth Circuit Courts of Appeal support Harry’s statement. Both circuits have agreed that an expert when modeling a plaintiff’s lost profits must take into consideration other causes affecting revenue and expenses. When overturning a plaintiff’s verdict, the Eighth Circuit stated, the expert’s model “was not grounded in the economic reality of the…relevant market, for it ignored inconvenient evidence. The [expert’s] model failed to account for market events that both sides agreed were not related to any anticompetitive conduct.”[16]
In a different decision, the Eighth Circuit excluded an expert’s opinion because “the expert considered only the alleged wrongful act of the defendant and did not take into account any of the other independent variables that might affect the conclusion.”[17]
The Fifth Circuit’s position echoes the Eighth. When upholding the exclusion of an expert’s testimony, the court said, “[The expert] did not consider whether the plaintiff’s firms were even capable of handling the excess capacity the projected rates of return necessarily entail. Moreover, characterizing all variations between the trade association earnings data and the plaintiff’s respective earnings as ‘lost profits,’ no allowance is made for losses caused by other factors; including, for example, reductions in shelf space attributable to other dominant firms or new entrants into the relevant markets, the plaintiff’s own failure to compete for shelf space on the terms sought by the retailers, and their lack of capacity or efficiency relative to other firms.”[18]
Conclusion
Financial modeling is widely used outside of litigation. Individuals, businesses, lenders, and investors use such models. Businesses apply financial modeling for budgeting and benefit/cost analyses. The same type of models may also be used in stress tests for financially impaired companies.
This same technique provides experts with the opportunity to provide realistic and reasonable assessments of lost profits. Modeling allows an expert to adjust cash flow projections for the impact of factors not related to the alleged wrongful act; therefore, adjusting cash flows to present only the losses related to the lawsuit. Modeling helps reduce uncertainty in the expert’s projections.
When modeling, there is not one model that must be followed for assessing lost profits. Harry notes that it is the expert who must decide how to model these losses. “Business damages may be determined using alternative methodologies and discount rates. The expert’s choices are not necessarily limited or constrained by certain ‘purported’ laws or principles of finance and economics when derived from ‘immediate situations’ not germane to a plaintiff forced away from its but for world. Instead, an expert may select from a range of theories, practices, and metrics developed outside of the litigation system.”[19]
This article has revisited modeling and why it is important when assessing lost profits. Accounting and financial writings along with appellant court opinions have highlighted the importance of adjusting the plaintiff’s projections to reduce uncertainty. Modeling is the first step in determining the value of future lost profits. The second is discounting those future losses to present value. The arguments over discount rates and risk premiums have not been addressed here. That topic has been saved for a later discussion.
[1] Robert Dunn, Everett Harry, “Modeling and Discounting Future Damages,” Journal of Accountancy, January 2002.
[2] Dunn, Harry, 1.
[3] Everett Harry, “Lost Profits and Lost Business Value—Differing Damages Measures,” Dunn on Damages, Issue 1, Winter 2010, 6.
[4] “Focus more on ‘CF’ than the ‘D’ says Damodaran,” BVWire Issue #173-1, 2/1/2017, Business Valuation Resources.
[5] Karl Dial, Nicole Figueroa, Lost Profits, A Guide for Achieving a Credible Damages Analysis in Texas, DLA Piper, 5.
[6] Gaughan, Patrick, Measuring Business Interruption and Other Commercial Damages, 2nd Edition, John Wiley & Sons, Inc., 2009, 49–50.
[7] PPC’s Guide to Litigation Support Services, Vol 1, 18th Edition, Thomson Reuters, July 2013, 4–22.
[8] Harry, 7–8.
[9] Dunn, Harry, 1.
[10] Dunn, Harry, 2.
[11] “Financial Modeling Overview,” Financial Modeling, Investment Banking Technical Training, Street of Walls, www.streetofwalls.com/finance-training-courses/investment -banking-technical-training/financial-modeling/, 3.
[12] “Guide for Prospective Financial Information with Conforming Changes as of May 1, 2003”, AICPA Audit and Accounting Guide, AICPA, 6.27, 21.
[13] Christopher Sontchi, “Valuation Methodologies: A Judge’s View,” ABI Law Review, Vol. 20:1, 2012, 8.
[14] Doron Kenter, “Always Sunny in Adelphia—Bankruptcy Court Rejects DCF with Unreliable Projections, Drops Some Valuation Knowledge, Weil Bankruptcy Blog, 5/28/2014, 2.
[15] Harry, 7.
[16] Concord Boat Corp. v. Brunswick Corp., 207F.3d 1039 (8th Cir. 2000).
[17] Blue Dane Simmental Corp. v. American Simmental Association, 178 F.3d 1035 (8th Cir. 1999).
[18] El Aguila Food Products, Inc. v. Gruma Corp., 131 Fed. Appx. 450 (5th Cir. 2005).
[19] Harry, 9.
Allyn Needham, PhD, CEA, is a partner at Shipp, Needham & Durham, LLC, a Fort Worth-based litigation support and economic consulting firm, where he is beginning his twentieth year as a litigation support expert. Prior to joining Shipp, Needham & Durham, he was in the banking, finance, and insurance industries. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial economics and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation and bar association meetings.
Dr. Needham can be reached at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.
