Use of DCF method.
Estimating cash flows. How
do courts make predictions about future
earnings? Not surprisingly, the courts often
hew to the seemingly safe ground of history—generally
relying heavily or exclusively on a company’s
past performance when predicting future
results. After all, when undertaking an
enterprise already fraught with as much
uncertainty as valuation, a set of historical
accounting records can seem like a warm
safety blanket. Consider the court’s
approach in the case of Central Trust
Company v. United States, revered as
a classic among legal valuators.
Financial analysts—who do not live
solely in the past—balk at such heavy
reliance on historical earnings to extrapolate
future results. They also find peculiar
the courts’ contentedness to engage
valuators only on a superficial level—choosing
arbitrary conventions such as “splitting
the difference” between competing
valuation reports or applying simple, mechanical
“formulas” as in Central
Trust rather than mix it up on the
playing field of financial theory. Few would
argue that this brand of judicial decision-making
has any significant relationship to reality.
Some suggest it may be jurisprudence undertaken
in the spirit compromise and expediency
rather than pursuit of justice or truth.
Bolder critics have argued that the judiciary
is devolving into a state-run mediation
program when valuation issues arise—a
program in which all the participants know
at the outset that the endgame is a middle
ground where questions of right and wrong
are of secondary importance.
Should we, as lawyers and managers, demand
that judges dive deeper than historical
accounting records and compromise solutions?Consider
the following cases in which the court looked
beyond the financial statements to make
judgments about future earnings.
Hooper v. Commissioner
41
B.T.A. 114 (1940)
In this estate tax
case, the decedent’s estate
included a minority interest in
the family business, a corporation
engaged in the business of manufacturing
and selling cotton fabric.The company,
however, was not in good shape.
At the time of valuation, the country
was emerging from depression. In
the preceding years, the company
had been consistently losing money.
There was a definite trend toward
diminishing value.
In projecting the
company’s future earnings,
however, the Board of Tax Appeals
chose to ignore the history of negative
earnings and look to immediate economic
conditions which would indicate
a rosier going concern value.The
Board opined that:
The evidence discloses that the
company had a poor earnings record.
In 1932 it operated at a loss
of $165,404, and its total net
loss for the period 1926 to 1932
(including the profit and loss
of its selling agent prior to
January 1, 1932, the effective
date of the merger) was $59,683,
or a loss of $5.77 per share.
In March 1933, after the bank
holiday, its business increased;
and on August 3, 1933, it could
reasonably have been anticipated
that it would realize, and it
did realize, a substantial profit
for the year. The testimony of
petitioner's witnesses convinces
us, however, that the increase
in business and profits following
the bank holiday in 1933 was largely
due to fear of a violent sudden
inflation, and to the rise in
the prices of raw materials when
the country went off the gold
standard. It therefore was not
a true indication of what might
be expected in the future.
Had the lawyers and
Board of Tax Appeals not looked beyond
the pure “numbers,” a
vastly different result would have
been had. |
Diefenthal v. United States
343
F. Supp. 1208 (1972)
Also a tax case, the
court in Diefenthal was
attempting to value plaintiff’s
scrap iron business. The court in
this case was presented with financial
statements that gave the impression
that the company had relatively
low earnings considering the amount
of business it was doing. In looking
beyond the financial statements,
the court noted that the company
had close business relationships
with several other companies that
happened to be owned by a family
member. It appeared that a portion
of the earnings of the related companies
should have been imputed to the
scrap iron business—in essence
finding that some of the company’s
income had been “siphoned
off” by the other businesses.
The court added this “collateral
income” to the company’s
earnings and used the adjusted figures
as the basis for projecting future
income.
|
Hooper and Diefenthal
are simple, straightforward examples of
judicial scrutiny extending beyond historical
accounting data and deceptively simplistic
“weighting” procedures. Who
bears the responsibility for ensuring that
courts ground their decisions on sound financial
theory rather than short-cut compromise
measures? Most judges—burdened by
an overextended docket—will say the
lawyers do.
|
Example
James Heekin began business as a coffee
roaster in Cincinnati, Ohio in 1864.Business
was good, and he began selling other dry
goods such as baking powder, spices, and
tea. As business expanded, he also began
making his own tins to package the goods.Ninety
years later, the Heekin Can Company was
a $17 million business with five plants
throughout the Midwest.
Since its founding, the company remained under
tight family control.In 1955, two of James’
sons—both of whom had served as president
of the company—died, and their ownership
interests in Heekin passed to their children.
These gifts of amounted to over 70,000 shares
of company stock (about 25% of the outstanding
shares). At the time of distribution, the
executors of both estates filed estate and
gift tax returns declaring the stocks’
value to be $10 per share.The executors later
amended these declarations to $7.50 per share.
The IRS had a different idea about the value
of Heekin shares: $24 per share. Of course,
litigation promptly ensued. Central Trust
Company v. United States, 158
Ct. Cl. 504, 305 F.2d 393 (1962).
The claims court embarked upon a valuation
of Heekin using the DCF methodology. It
started out on a standard tack: focusing
on the historical accounting data from the
previous five years. These data would then
be used to forecast future earnings—making
estimates in accord with the historical
trend. Not so easy, however.The earnings
over the previous five years had been irregular.
The Korean War had created a temporary surge
in the need for cans, resulting in increased
revenues. Also, several large charges were
made against earnings for one-time losses.
The court analyzed these abnormalities and
adjusted Heekin’s earnings to normalize
the financial statements. Even still, a
clear trend in earnings was hard to discern.
The adjusted earnings figures were as follows:
| Year |
Adjusted
earnings |
1950 |
$325,654.77 |
1951 |
$421,590.98 |
1952 |
$307,750.07 |
1953 |
$547,040.03 |
12 months ending
Sept. 30, 1954 |
$507,429.06 |
How should the court use this information
to predict future earnings? Business is
improving, but only in fits and starts.
You could average the earnings for the period.
But this might give undue weight to the
low earnings of the first year. The court’s
solution: give more relative weight to recent
earnings. How much weight? Very simple:
Beginning with the most recent year, the
court multiplied the earnings by 5, 4, 3,
2, and 1 respectively. The average is then
taken by dividing the sum by the total of
the multipliers (15).
The difference is not tremendous, but also
not insignificant. A straight average of
the five-year earnings is $421,892.99. Using
the court’s weighted method, the average
is $454,492.83.
Conceptually, this approach seems a little
more satisfying than arbitrarily calculating
an average—especially if you are a
firm believer that more recent earnings
are a better indication of future results.
The court gives effect to a general trend
in earnings. But no connection is articulated
between the method and the conditions of
the company. Maybe 1953 is a better indication
of future earnings—maybe not. |
5.6 Business Valuation in Legal Contexts 