The Investment Treaty Arbitration Review: The Discounted Cash Flow Method of Valuing Damages in Arbitration
The discounted cash flow (DCF) model is a widely used method of valuing assets and, as a result, has become an important tool for estimating damages in the context of international arbitration.
In this chapter, we present an overview of the DCF methodology, explain the typical steps a practitioner should follow when implementing a DCF valuation, set out examples where a DCF model may not be suitable as the main method for estimating damages, and discuss some extensions to the traditional DCF framework.
II Overview of the DCF valuation model
The DCF method is one of the three main valuation approaches commonly used for the purpose of quantum damages assessment in international arbitration, alongside the market-based comparables method and the asset-based method.2
Under the DCF method, the market value of an asset is estimated as the present value of expected future cash flows, discounted back to the valuation date using an appropriate discount rate, which reflects the risks around the expected cash flows, as illustrated in Equation 1, below.3
The DCF model shown in Equation 1 is versatile and can be used to estimate the value of a business as a whole or to estimate the value of equity directly, with the cash flows and discount rates defined accordingly.4 In Table 1 below, we set out the typical derivation of cash flows used to estimate the value of a business as a whole (also known as enterprise value).
Table 1: Derivation of free cash flows for valuation of a business as a whole
|Derivation of cash flows to the firm||Location in financial statements|
|+ Revenues||Income statement|
|- Operating costs||Income statement|
|- Taxes||Income statement|
|- Investments in working capital||Calculated from balance sheet or cash flow statement|
|- Capital investment costs||Calculated from balance sheet or cash flow statement|
|= Free cash flows to the firm|
The DCF method relies on the fundamental principle that economic agents value assets based on the expected future benefits from owning these assets. This principle is not unique to the DCF method, but applies equally to the alternative market-based comparables valuation method. Under the DCF method, the expected benefits in the form of cash flows are explicitly modelled and discounted back to the valuation date to estimate market value. In the case of a market-based comparables valuation method, assets are valued using prices paid for comparable assets, but these prices themselves have embedded in them the expectations of market participants on the expected future benefits of owning the assets. The DCF and comparables methods, therefore, are often complementary to each other, given they are built on the same principle that value is driven by future economic benefits of owning a given asset.
A key feature of the DCF method is that it provides flexibility to incorporate assumptions around key value drivers into the valuation result and, therefore, enables the valuer to take account of the specific operational features or market conditions concerning the asset in question. In contrast, under the market-based comparables approach, the value drivers are implicitly reflected in the market prices of 'comparable assets' and cannot easily be modified to reflect the specifics of the asset being valued. The market-based method, therefore, relies on the ability of the valuer to identify market prices of relevant comparator companies (i.e., companies with similar prospects in terms of expected future cash flow generation and risk as the business being valued). Finding relevant comparators with very similar operating and market conditions may be a challenging exercise, especially in the context of international arbitration, where assets in dispute frequently exhibit unique characteristics, with comparable transactions rare or even non-existent.5
The flexibility of the DCF method to explicitly incorporate specific assumptions around key value drivers in the valuation model allows it to be used in a wide range of applications in the context of international arbitration, including valuation of businesses following expropriation, lost profits arising from construction delays, contract breaches, or changes in regulatory conditions, and any dispute more broadly that has implications for future cash flows of a business or project.
Despite the theoretical appeal of the DCF model, a valuation result produced using the DCF method will be reliable, only if it is based on reliable assumptions around expected future cash flows and risks. However, these assumptions are not directly observable and must instead be carefully estimated, as we discuss in the following section.
III Implementation of the DCF model in damages estimation
The implementation of a DCF model requires estimating future cash flows and discounting these cash flows using a rate that reflects the risks around these expected cash flows, as illustrated in Figure 1, below.
In the rest of this section, we discuss the steps that a practitioner should follow when implementing a DCF model in the context of damages estimation.
i Estimating revenues
Revenue projections are typically one of the key components of a DCF valuation or damages calculation, given the other components of cash flows (operating costs, capital costs, working capital investments or taxes) themselves frequently depend on the projected revenues.
There are a number of sources of information that can be analysed to inform revenue projections.
As a starting point, data on historical performance of a business can often provide a basis of projecting revenues into the future. However, the past may not always be a relevant guide to the future, for example, in situations where companies may be planning to expand, or conversely where they expect to be negatively affected by prospective market developments. It is critical, therefore, when undertaking a DCF valuation to consider the fundamental drivers of the cash flows of the business going forward, as opposed to simply extrapolating from past performance recorded in a company's financial statements, which could potentially overlook prospective changes in the business and economic conditions, the competitive environment, technological changes, regulatory changes, among other things.
One important source of forward-looking evidence includes business plans prepared by a company's management. However, business plan projections should not be used in a DCF valuation without a critical review of their reliability (as illustrated in Figure 2, below). For example, the valuer may explore the extent to which the projections are supported by contracts the company has in place with its customers, which could provide some degree of certainty around the forecast revenues. The valuer may also look at previous business plans to assess how accurately management was able to forecast the company's performance in the past. The reliability of the business plans may also be supported by third party reliance on the projections (e.g., by financing banks).
- Are the forecasts supported by historical company performance?
- Does company management have a history of producing credible forecasts?
- Have any other parties endorsed or relied on these forecasts, such as banks or investors?
- What is the basis of the financial projections? Are they supported by contracts, market price and size analysis or other market research?
- Are the forecasts in line with projections by others (e.g., analyst reports, industry publications)?
- Are forecasts consistent with comparators in the same sector and can any discrepancies be explained?
In addition to considering internal company forecasts, another source of relevant forward-looking evidence includes external forecasts for the firm in question, competitor firms, or the relevant industry or sector as a whole. Considering external forecasts is useful to understand how the forecasts for the firm in question compare to the wider market evidence (for example, it may not be reasonable to expect that a mature firm would be able to grow faster than the market in which it operates). Sources of external forecasts include, for example:
- analyst reports from investment banks and research houses, which may provide financial projections for the company in question or similar companies operating in the same sector or geographical location;
- market research firms, which provide periodic forecasts on the expected development of certain sectors and industries as a whole; or
- specialist adviser firms, which focus on specific sectors or geographical locations and may provide more specialist and tailored forecasts than the above alternatives.
ii Estimating operating costs and overall profitability
Projections of operating costs and the resulting operational profitability of a business are another key component of a DCF valuation or damages calculation.
The sources for establishing reliable projections of operating costs and operational profitability (commonly measured by the EBITDA margin6) are generally similar to the sources discussed above in the context of revenue projections, including historical performance of the firm in question, management business plans or external forecasts from analyst reports and other sources.
In assessing projections of overall profitability, it is also common to consider profit (EBITDA) margins for comparator companies, to assess how the projections for the company in question compare to the wider market evidence. For such comparisons, care must be taken to ensure that the comparator companies are truly comparable (e.g., that they generate revenue from similar types of products, operate in similar geographical locations and are at a similar level of maturity as the company in question), as profitability within sectors can vary significantly based on these factors.
iii Estimating capital costs
Capital investment costs are another important cost category of a DCF valuation or damages calculation.
The capital investment needs for a business typically differ based on the company's stage in its life cycle. If a company is forecasting an expansion of its business, substantial capital investments (e.g., in new production facilities) are likely to be needed to support the growth. For mature companies with a stable market share, capital investment needs typically cover the replacement and regular maintenance of existing assets.
To inform capital investment cost projections, the valuer may review the historical capital investments of the company, differentiating between investments used to support growth and investments required for maintenance and replacement of existing assets. Benchmarking against comparator companies may also provide relevant information about whether the assumed capital investments and the resulting level of fixed assets are able to support the projected revenues.
iv Estimating working capital investments
Working capital of a business is defined as the difference between current assets (typically accounts receivable, inventories and operational cash holdings) and current liabilities (typically accounts payable). It is used to assess a company's short-term financial health but also measures how efficient a company is at converting resources into production and ultimately into cash.
Working capital is sometimes an overlooked element in valuation but there are situations where it can have a large effect on the value of a business. Benchmarking working capital against comparator companies operating in the same markets may provide relevant evidence for whether the company's working capital position is in line with industry practices, or whether substantial investments and divestments are to be expected, with a corresponding effect on the value of the business.
v Estimating the long-term growth rate and terminal value
If damages accrue over an indefinite period, it is common to assume that, after a certain amount of time, the business will reach a steady state and cash flows will continue to grow at a stable long-run growth rate from that point onwards, giving rise to the 'terminal value'.7
The terminal value can often drive a substantial portion of the overall DCF value of the business and, therefore, should be carefully considered. Typically, valuers assume a long-run growth rate in cash flows in reference to economic fundamentals (e.g., forecast long-run inflation growth or long-run economic growth of the relevant countries in which the company operates).
However, there are many situations in which a constant perpetual growth rate is not an appropriate assumption, such as for resource industries with diminishing reserves, for companies dependent on patent protection, or for industries subject to material risks from disruptive innovations (e.g., high-tech industries). In such circumstances, more sophisticated methods of projecting cash flows need to be undertaken.
The terminal value is also a direct function of the final year cash flow underlying the DCF projections for the explicit modelling period. Small changes in assumptions in this final year can materially affect the terminal value calculation, and care needs to be taken to fully cross-check the reasonableness of the final year projections.
vi Estimating the appropriate discount rate
To take into account the time value of money as well as relevant risks, the forecast cash flows are discounted back to the valuation date using an appropriate discount rate. The most common formula used to estimate a discount rate is the weighted average cost of capital (WACC).
The WACC represents the weighted average of the cost of debt and cost of equity, where the weights are determined by the relative proportions of debt and equity financing in the capital structure of the business, as illustrated in Equation 2, below, where:
- g is the level of gearing (share of debt in overall capital structure);
- Ke is the cost of equity; and
- Kd is the cost of debt.
There are general methodologies for estimating the individual components of the WACC formula (e.g., using the capital asset pricing model (CAPM) for estimating the cost of equity). However, the assumptions to populate the general models (such as the CAPM) are specific to the company in question and the risks it faces going forward and need to be carefully assessed by the valuer.
Care must also be taken to ensure that the discount rate calculation is consistent with other assumptions in the DCF model, such as how inflation is treated in the model (forecast cash flows in nominal terms should be discounted using a nominal WACC), how tax is treated in the model (forecast cash flows after taxes are subtracted should be discounted using a post-tax WACC) or how currency risk is treated (the cash flows and WACC should be calculated based on the same currency).
IV Circumstances where the DCF may not be appropriate
A DCF model can be used, in theory, for the purpose of valuing any asset or business. However, the appropriateness of relying on a DCF model for the purpose of damages estimation depends on whether the key DCF assumptions can be estimated with reasonable certainty.
Although there are no hard and fast rules on how to establish whether DCF assumptions are reasonably certain, below we provide some examples of where the use of a DCF model may not be suitable as the main method for the purpose of damages estimation.
i Example 1: Use of DCF for early stage investments
One example where the appropriateness of using a DCF method for estimating damages has been questioned is the case of early stage investments with limited or no operational history. This poses a challenge for a DCF model because it means that there is no history of cash flows that can be relied on as the basis for forecasting future cash flows.
However, whether the DCF method can be used to reliably estimate damages for early stage investments depends on the individual circumstances of the case.
There may be situations where an early stage business can have some certainty around future cash flows even without having any operational history. Examples of such cases may include investments where future earnings are based on explicit promises of government subsidies (e.g., feed-in tariffs for renewables), investments where future revenues or prices are subject to regulatory oversight (e.g., regulated infrastructure) or investments where reliable forecasts of future prices or sales volumes can be obtained based on market forecasts or contractual arrangements (e.g., in extractive industries).
Some examples of where tribunals have relied on the DCF model for estimating damages for early stage investments are Masdar v. Spain (solar and wind generation),8 Devas v. India (telecommunications),9 Gold Reserve v. Venezuela (gold mine)10 and Lemire v. Ukraine (telecommunications).11
Notwithstanding these examples, according to a recent survey of 2019 awards, tribunals' decision-making appears to have opted against the DCF model in favour of the cost-based approach in the vast majority of cases involving early stage investments.12
ii Example 2: Use of DCF compared to other available methods
The appropriateness of any valuation method depends on the availability of alternative approaches and the differences in valuation results produced by the different methods.
In any calculation of damages, it is important to cross-check the result of the DCF method against available alternatives. A cross-check of the DCF against the market-based comparables method is particularly relevant, given the two methods rely on the same fundamental principle that the value of an asset is driven by expected future benefits of owning the asset (as explained in Section II).
There may be cases where the application of a DCF method may be difficult and a market-based comparables valuation will provide a more reliable result. For example, if a company's historical performance has been very volatile or a company operates in a highly cyclical or disruptive industry, a valuer may need to make a large number of assumptions about the future evolution of the business in a DCF framework. In such circumstances, alternative methods of valuation, such as relying on traded multiples from comparator companies, might be more reliable as a basis for calculating damages, since this approach relies directly on how the market values the relevant risks and opportunities going forward, as opposed to relying on assumptions made by the valuer under a DCF.
Another important cross-check of the DCF valuation result is to compare it to prices paid in any prior transactions involving the asset in dispute itself (if available). If there are material increases or decreases in value of the asset implied by the DCF valuation by comparison to market prices observed in previous transactions, this needs to be reconciled with changes in underlying cash flows or risk.
V Extensions to DCF
In this section, we discuss some variants and extensions to the traditional DCF approach, namely the 'modern' DCF, the capitalised cash flow (CCF) approach and the direct capitalisation approach.
i 'Modern' DCF
The 'modern' DCF is a variant of the traditional DCF, originally proposed in 1985 by Brennan and Schwartz for the purpose of valuing natural resource projects.13
The key difference between the 'modern' DCF and 'traditional' DCF is in their treatment of risk, as illustrated in Figure 3, below. In a 'traditional' DCF, cash flows are forecast to reflect their expected values and risk associated with the future operations of the asset is reflected in the 'risky' discount rate. In the 'modern' DCF, risk is instead incorporated directly into the cash flow forecasts in the form of a downward adjustment and these risk-adjusted cash flows are subsequently discounted using the 'risk-free' rate.
The risk-adjusted cash flows in the 'modern' DCF, also referred to as certainty equivalents, represent a cash flow that an investor would be willing to receive with certainty instead of the risky expected cash flow. The certainty-equivalent cash flows are lower than the expected risky cash flows, because investors are risk averse and would be willing to pay (forego income) to avoid risk.
The advantage of the 'modern' DCF method is that it provides greater flexibility in how to incorporate risk adjustments into the valuation (e.g., by taking into account changes in risk over time). However, the challenge with the approach is how to adjust the expected cash flows reliably for risk to estimate their certainty equivalents, which may limit the application of the model in practice.
One example where risk-adjusted cash flows can be estimated directly from market data is if future risk is driven by commodity price fluctuations, owing to the existence of futures contracts in these markets. Futures contracts represent contracts to buy or sell commodities at a given price on a given date in the future, thus 'locking in' a price for the commodity in the future with certainty. The prices of commodity futures, therefore, represent risk-adjusted prices or certainty-equivalent prices and can be used directly to estimate certainty-equivalent cash flows adjusted for commodity price risk.14
The 'modern' DCF method was applied in Tethyan v. Pakistan, which concerned the expropriation of copper mining assets.15
ii Capitalised cash flow approach
The CCF approach is a variant of the DCF approach, which projects cash flows for only one year into the future and assumes that, from that point, cash flows will grow at a constant growth rate.
The market value of an asset under the CCF approach is calculated based on the formula in Equation 3, below (which is equivalent to the terminal value calculation formula in a 'traditional' DCF valuation).
The CCF method is referred to as a 'shortcut' method by sources such as Shannon Pratt's Lawyer Business Valuation Handbook,16 because it is based on the restricted assumption that cash flows grow at a constant rate in all future years after the initial forecast year.
Given this assumption, the application of a CCF approach is only appropriate if there is a strong reason to believe that the asset or business will receive stable cash flows over time (e.g., a mature company with stable market share operating in a market with limited volatility and a history of stable cash flow growth).
iii Direct capitalisation approach
The direct capitalisation approach is another variant of the DCF approach, which can be used for valuing assets that are expected to have a constant stream of cash flows.
This approach values assets based on two inputs only (as set out in Equation 4, below):
- the project's net operating income (NOI); and
- the capitalisation rate, which reflects the target rate of return for a project.17
The direct capitalisation approach is discussed and applied in the context of real estate valuation literature, for valuing property generating rental income.18 Practitioners often derive the capitalisation rates from comparable market transactions,19 as well as from published real estate investor surveys, which typically track the capitalisation rate for various sectors of the real estate market.20
Well-constructed DCF models can be a highly effective tool for the valuation of a business, as they allow the practitioner to fully account for a business's individual circumstances and expected future performance. However, the effectiveness of a DCF valuation relies on careful practical implementation. In particular, it is crucial that the key assumptions (i.e., future cash flows and the discount rate) are estimated with reasonable certainty to provide a reliable estimate of value.
Although several variants of the traditional DCF method have arisen over the years, the traditional DCF remains a popular choice for practitioners and tribunals alike. It remains to be seen whether these variants become more established in future international arbitration awards.
1 Richard Hern is a managing director, Zuzana Janeckova is a senior consultant and Tarek Badrakhan is an economic analyst at NERA Economic Consulting.
2 The three main methods for estimating the market value of an asset or a business are (1) income-based approach: estimates the market value of an asset or business by calculating the net present value of the future expected benefits (e.g. discounted cash flows (DCFs) or dividends), (2) market-based approach: estimates the market value of an asset or business by reference to similar businesses, business ownership interests and securities that have been sold in the market and (3) asset-based approach: estimates the market value of a business as the market value of its assets less the market value of its liabilities (e.g., based on adjusting the assets and liabilities in the balance sheet to their market value).
3 For a detailed discussion of the history of how the DCF model was developed, see J Makholm and L Olive, 'The discounted cash flow method of valuing damages in arbitration', The Investment Treaty Arbitration Review (Fourth Edition, Chapter 22).
4 In the case of a whole business valuation, the cash flows in Equation 1 are defined as cash flows to the firm, i.e., cash flows before the effects of debt financing, and are discounted at the weighted average cost of capital (WACC), which represents the weighted average of the cost of equity and debt financing. In case of an equity valuation, the cash-flows in Equation 1 are defined as cash-flows to equity, i.e., cash flows calculated after the effects of debt financing, and are accordingly discounted at the cost of equity only.
5 For more details on the comparables valuation method, see R Hern, Z Janeckova, Y Yin and K Bivolaris, 'Market or Comparables Approach', The Guide to Damages in International Arbitration (Fourth Edition, Chapter 17).
6 EBITDA stands for earnings before interest, taxes, depreciation and amortisation and represents a common measure of profitability of a business. Because it is a measure of profitability before taking into account interest costs, depreciation and amortisation or taxes, it is a measure of operational profitability which is not distorted by companies' financing decisions, differences in tax regimes or accounting policies.
7 The length of the period until the business reaches a steady state may differ depending on the circumstances, but generally should represent a period after which no material changes are expected to affect the company's cash flows.
8 Masdar Solar & Wind Cooperatief U.A. v. Kingdom of Spain, ICSID Case No. ARB/14/1, Award (16 May 2018), para. 581 ('[t]he Tribunal considers that the circumstances of the present case warrant use of the DCF method for assessing the fair market value of Claimant's investments. . . . Although the Plants that Claimant invested in had only operated for a relatively short period of time prior to Respondent's adverse measures, it was clearly sufficient to generate adequate information for the calculation of future income, which could have been expected with reasonable certainty, thus qualifying as “going concerns”.')
9 CC/Devas (Mauritius) Ltd., Devas Employees Mauritius Private Limited, and Telcom Devas Mauritius Limited v. Republic of India, PCA Case No. 2013-09, Award on Quantum (25 Jul. 2016), paras. 537–40 ('the Tribunal has come to the conclusion that it is appropriate in this case to use a DCF analysis to establish the value of the value of Devas. . . . the Tribunal further finds there was a “solidly-formulated long-term contract” in the Devas Agreement, all in the context of explosive demand in India for the data services Devas was expecting to provide').
10 Gold Reserve Inc. v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/09/1, Award (22 Sep. 2014), para. 580 ('Although the Brisas Project was never a functioning mine and therefore did not have a history of cashflow which would lend itself to the DCF model, the Tribunal accepts . . . that a DCF method can be reliably used in the instant case because of the commodity nature of the product and detailed mining cashflow analysis previously performed.').
11 Joseph Charles Lemire v. Ukraine (II), ICSID Case No. ARB/06/18, Award (28 Mar. 2011), para. 254 ('The only aspect on which both experts have agreed is that the appropriate methodology to establish the damage in a case like this one is a DCF analysis. . . . Given this acceptance and the common proposal of both experts, the Tribunal sees no difficulty in using a DCF methodology.).
12 T Oyewole, S Stockley and C Adams, 'Early-Stage Investments and the “Modern” DCF Method', The Guide to Damages in International Arbitration (Fourth Edition), p.246.
13 M Brennan, E Schwartz (1985), 'Evaluating Natural Resource Investments', Journal of Business.
14 In practice, real-life assets will be exposed to a range of risks, which would need to be adjusted for separately when calculating certainty-equivalent cash flows for an asset as a whole.
15 Tethyan Copper Company Pty Limited v. Islamic Republic of Pakistan, ICSID Case No. ARB/12/1, Award (12 Jul. 2019), paras. 336–65. The tribunal accepted the claimant's approach of calculating damages by adjusting future cash flows for individual risks affecting those cash flows (e.g., copper price risks, project delays, early termination) and discounted these risk-adjusted cash flows at the risk free rate.
16 S Pratt, The Lawyer's Business Valuation Handbook (American Bar Association, 2000).
17 T Sevelka (2004), 'Where the Overall Cap Rate Meets the Discount Rate', The Appraisal Journal, p. 135.
18 C H Wurtzebach and M E Miles, Modern Real Estate (4th ed., John Wiley and Sons, Inc., 1991), p. 217.
19 Practitioners can calculate the implied capitalisation rate of comparable transactions as the net operating income divided by the transaction value.
20 T Sevelka, op. cit. note 17, above, p. 135.