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Three Essential Factors in Estimating Business Value or Commercial Damages

The income approach is a common and accepted manner of estimating the value of both publicly-traded and closely-held businesses, as well as calculating certain types of commercial damages. The most common method within this approach is known as “discounted cash flow” or DCF. Although there are a number of variations within this method, it is common for practitioners to only analyze accounting-based financial statements of the subject company from the most recent few years, and use these as the basis to estimate the future growth rate of revenue and costs.

In this paper, we first demonstrate the widespread use of this method, citing a number of authorities. We next show how the standard DCF method, although it typically involves a hundred or more individual entries in a number of tables, actually relies heavily on just three critical factors: the share of revenue that is distributable profits; the growth path of revenue; and the discount rate. Given this framework, we review commonly-used business valuation references, and show how they often provide little guidance on estimating the growth rate in revenue. We note that an examination of the factors underlying the growth rate assumption are often explicitly required by case law, statute, or regulation. We also note briefly that the basic assumptions of the “build up” CAPM model are violated when applied to privately-held firms.

We next demonstrate how changing any of these critical factors substantially affects the valuation or commercial damages estimates, using two case studies based on actual companies.

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