Looking Back to Go Forward

A Review of the Basics for Lost Profits (Part V)

This is the fifth article in a series reviewing the basics for lost profits. When calculating lost profits, some assignments will show results with future lost profits. The future lost profits must be discounted to a present value. This article will review issues relating to discounting future lost profits to their present value. The topics discussed will be (1) from what date to discount losses, (2) ex ante and ex post approaches, (3) modeling or not modeling projections of future losses, and (4) the appropriate discount rate.

This is the fifth article in a series reviewing the basics for calculating lost profits. This article will review issues relating to discounting future lost profits to their present value. Topics discussed will be (1) from what date to discount losses, (2) ex ante and ex post approaches, (3) modeling or not modeling projections of future losses, and (4) the appropriate discount rate.

When calculating lost profits, some assignments will show results with future lost profits. The future lost profits must be discounted to their present value. “Future damages must be discounted to present value. It is part of plaintiff’s burden of proof to offer evidence of the present value of a future stream of lost income. Without evidence of the appropriate discount rate, plaintiff has not made out its case. An award of undiscounted future lost profits should be set aside.”[1]

Loss Period

Not all lost profit assignments will provide future lost profits. The setting of the loss period (which will determine if there are future losses) is a critical part of any assignment. “Determining the length of time an entity was affected by the alleged damage is an important consideration and certainly affects the projection of lost revenue. Sometimes, but not always, the loss period is an assumption provided to the damages analyst by the attorney-client based either on case facts or applicable law. … Instances may occur when the damages analyst will be required to determine independently, based on an evaluation of the data (i.e., without being provided an assumption), when losses may have ceased, if at all. To evaluate when losses ended, the analyst may evaluate when ‘normal’ (or but-for) revenue levels were consistently re-attained by the damaged entity. Such a result could signal an end of the damages period.”[2]

By setting the loss period, the financial expert will know if any of the estimated lost profits will be in the future. Past lost profits run from the date beginning the alleged wrongful acts through the date of trial or judgment. Future losses may be defined as losses occurring after the date of trial or judgment. In assignments where future lost profits are calculated, it is the future lost profits that should be discounted to present value.

“A plaintiff will claim lost profits for an identified time period, known as the period of damages, damages period, or the period of recovery. The damages period may last less than one day to perpetuity. The period of damages usually, but not always, commences on the date of alleged legal wrongdoing. The end of the period of damages will vary depending on the issues of law and relevant case facts.

The period of damages may include past damages and future damages. Past damages are those losses occurring from the onset of the damages period through the date of judgment (or other dispute resolution date). Future damages are any losses expected to occur after that date. Courts generally require that lost profits calculations reflect totals separated into these two categories because future damages require conversion to present value, and the court might award interest on past damages.”[3]

Ex Ante, Ex Post

Some financial experts argue the lost profits should be discounted not to the date of judgment but to the date of the alleged wrongdoing. This argument takes on the Latin phrases used for the differing dates. A rough translation of ex ante is before. The translation of ex post is after.

It is seldom courts require an expert to discount all lost profits in an ex ante approach. The majority of cases involving future lost profits calculate the present value based on the ex post approach, which shows the beginning of future losses as the anticipated date of judgment.

This issue was addressed in the Energy Capital Corp. case. In this case, the appellant court noted, “Almost all of Energy Capital’s lost profits would have been earned after the date of judgement. … Accordingly, we hold that the trial court did not err in discounting Energy Capital’s lost profits to the date of judgment instead of the date of breach.”[4]

Unless specifically directed by the court or rules specific to that court to discount in a different manner, a financial expert may feel confident in discounting future lost profits to the date of judgment and to the date of the alleged wrongful act.

Modeling Future Lost Profits

Modeling is a technique that may be used to estimate future lost profits. “The income approach [for valuing a lost business] and the lost profits methodology both project the but-for economic income, although the period of loss may differ. The modeling techniques can be similar, if not identical. For example, projected but-for revenue for either methodology may use techniques of before-and-after, benchmarks or yardsticks, or projection.”[5]

Why is modeling important?

“The calculations associated with damages in the form of lost profits are often complex due to factors such as varying cash flows, extended time periods, and—in certain circumstances—the need for multiple scenarios to account for the likelihood of certain events occurring (or not occurring).”[6]

Why is this important for discounting future lost profits to present value?

“CPA expert witnesses frequently testify in court about damages assessments when a plaintiff alleges future economic losses because of a defendant’s wrongdoing. Some CPA experts project the plaintiff’s hope-for income stream, modify those losses to a realistic expectation by factoring in future risks, and then discount the adjusted future losses to a present value at a risk-reduced, relatively low discount 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.”[7]

Dunn and Harry go on to say that the first approach is easier for judges and juries to understand. After having applied this technique for over 20 years, I concur. I have found modeling and applying a risk reduced discount rate can make lost profits opinions more understandable and acceptable to the trier-of-fact.

But what do Dunn and Harry mean by modeling?

The idea of this concept is to minimize the differences between the plaintiff’s and defendant’s discount rates. “If the CPA expert addresses risk to the maximum practical extent in the model, he or she can employ a discount rate ranging from the risk-free or ‘safe’ rate to one that includes systemic risk premia.”[8]

To model calculations to discount future lost profits to present value, Dunn and Harry provide the following steps:

1. Prepare a spreadsheet model of the plaintiff-envisioned ‘success’ outcome. (This model includes lost revenue, saved costs, and the net lost profits.)
2. Identify the risks that the plaintiff likely will attain lower-than-hope-for results (e.g., recent decline in demand for products, supply chain issues from suppliers, economic downturn).
3. Adjust the spreadsheet model for these identified risks with the objective of generating a stream of undiscounted lost profits that reasonably approximates the most likely or ‘expected’ (in a probability sense) but-for income.
4. Calculate the present value for the risk-adjusted lost profits stream by using an appropriately risk-abated discount rate.[9]

Regardless of whether modeling is used to adjust the future lost income stream, the appropriate discount rate will vary. The appropriate discount rate has become a debated topic and one not likely to be settled anytime soon.

Discount Rate

The general legal point on discounting future lost profits is this: “Future lost profits should be discounted to present value at an appropriate rate because the purpose of the award of damages is to provide a fund that, including principal and interest, will yield plaintiff an amount equivalent of its loss.”[10] This leaves the door open for a wide interpretation of what is an appropriate discount rate.

Courts have held that the discount rate is a question of fact. “We do not hold that in every case a risk-adjusted discount rate is required. Rather, we merely hold that the appropriate discount rate is a question of fact.”[11] This means the facts of each case will determine the appropriate discount rate.

In the Energy Capital Corp. case, the appellant court went further to explain the discount rate and its use in discounting future lost profits:

“Energy Capital argues that the sole purpose in discounting is to account for the time value of money. Again, we disagree. When calculating the value of an anticipated cash flow stream pursuant to the DCF [discounted cash flow] method, the discount rate performs two functions: (i) it accounts for the time value of money; and (ii) it adjusts for the value of the cash flow stream to account for risk.”

Much of the debate regarding the appropriate discount rate has raged over whether only a risk-free rate should be used. I do not believe there are many financial experts that argue for a consistent use of only a risk-free rate to discount future lost profits but because the appropriate discount rate is based on the facts of the case, I do not close the door completely on applying a risk-free rate only.

In most litigation, the biggest dispute is related to how to assess the risk premia to be applied.

“The discount rate should account for two general types of risk beyond the risk-free or time-value-of-money component of the total discount rate. First, dispersion risk exists to the extent that a but-for outcome could vary from the expected stream of cash flows (i.e., the probability weighted average of the potential but-for outcomes). Greater potential volatility supports a higher discount rate. Second, plaintiff’s projections of cash flows may represent a hoped-for or successful outcome more than the expected result. If so, additional unsystematic risk premia may be appropriately included in the discount rate.”[12]

Some of the differences in the discount rates come from the way in which experts approach discounting future lost profits. Many experts come from practices based in the business valuation field. Their approach in determining the appropriate discount rate relies on the build-up method and the risk factors that are commonly used to determine capitalization rates in business valuation assignments. Other financial experts bring the same concept of a build-up approach but with a different assessment for valuing risk premia.  Regarding these differences, the courts have provided only marginal assistance in this matter.

“Some legal cases that discuss the appropriate discount rate relate it to a rate of return that is commensurate with the risk that the injured firm would have incurred if it had actually received the lost profits (but-for the injury). Following financial theory, future lost profits that are less certain result in a higher discount rate and, therefore, a lower present value (all things being equal). Conversely, future lost profits that are more certain of being received, use a lower discount rate and result in a higher present value (all other things being equal).”[13]

In other situations, “Some of the legal cases that discuss the appropriate discount rate use the rate of return that the injured party could earn by investing the court award.”[14] Benchmarks for the discount rate based on the investment rate of return include:

            Rate of return on a conservative investment;

            Rate of return on an investment portfolio;

            The injured firm’s cost of debt;

            The firm’s average weighted average cost of capital;

The injured firm’s cost of equity;

Rate of return from an investment similar to the injured firm if the business was destroyed.[15]

In my practice, I provide a discount rate that I believe represents the rate of return that is commensurate with the risk the injured firm would have incurred to generate the lost profits were it not for the alleged injury. I believe this is what the courts in my area of practice want.

I use a build-up method starting with the risk-free rate, which is related to the length of the future loss period (yield on three-year maturing U.S. Treasury securities for a three-year future loss period, the yield on seven-year maturing Treasury securities for a seven–year future loss period). I then show various risk premia specifically related to the injured firm and the case. Some of these are objective. Some of these are subjective. As with any analysis, the expert must have a reasonable explanation for the specific risk premia factor applied.

In the end, my discount rates for discounting future lost profits have been as low as 8 percent and as high as 36 percent. All these discount rates were accepted by the court.

Conclusion

Not all lost profits assignments will provide future lost profits. When the facts of the case allow for future losses, those losses must be discounted to present value. The present value of the calculation ultimately becomes the value as of the date of the trial or the date of judgment.

In calculating the lost profits, both past and present, the expert may choose to adjust initial projected revenue, avoided costs, and lost profits for risks that are known. By doing so, the expert makes the calculations and results more probable of reflecting the loss incurred by the injury business.

When determining the appropriate discount rate, the expert should consider the facts of the case and the amount of risk adjustment made in the cash flow analysis. The more confident the expert is in the projections, the less, it may be argued, the discount rate.

While Daubert challenges of the experts are common in almost all commercial damages cases, an expert can limit his or her exposure by following these steps and having well-reasoned answers as to why certain risk premia were included (or excluded) and why the percentage factor included in the build-up was appropriate. Experience has shown the courts are willing to accept a well-constructed and thought-out argument for an expert’s discount rate, so long as it is supported by the facts of the case. Experts preparing themselves for such cross-examination questions should be able to provide relevant and reliable information to the trier-of-fact in support of their report.

[1] Recovery of Damages for Lost Profits, Supplement March 2023, Robert Dunn, Editors, Sharon Rutberg, Wendy Malkin, 2023, p. 466.

[2] Lost Profits Damages, Principles, Methods, and Applications, Everett Harry, III, Jeffrey Kinrich, VPS, 2022, pp. 307–308.

[3] Ibid., p. 401.

[4] Energy Capital Corp. v United States, 302 F.3d 1314, 1330 (Fed. Cir. 2002).

[5] Lost Profits Damages, Harry, Kinrich, p. 144.

[6] Ibid., p. 479.

[7] Modeling and Discounting Future Damages, Journal of Accountancy, Online, Robert Dunn, Everett Harry, 12/31/2001.

[8] Ibid.

[9] Ibid.

[10] Lost Profits Damages, Harry, Kinrich, p. 99.

[11] Energy Capital Corp. v United States, 302 F.3d 1314, 1333 (Fed. Cir. 2002).

[12] Lost Profits Damages, Harry, Kinrich, p. 557.

[13] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3^rd. Ed., Vol. 1, Nancy Fannon, Jonathan Dunitz, BVR, 2014, p. 350.

[14] Ibid., p. 348.

[15] Ibid.

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Allyn Needham, PhD, CEA, is a partner at Shipp Needham Economic Analysis, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp Needham Economic Analysis, he was in the banking, finance, and insurance industries for over 20 years. 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 areas of financial and forensic economics, and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings. In 2021, Dr. Needham received a NACVA Outstanding Member Award. He is also a member of NACVA’s QuickRead Editorial Board.

Dr. Needham can be contacted at (817) 348-0213 or by e-mail to aneedham@shippneedham.com.