Bankruptcy court discredits DCF as too easy to manipulate

BVWireIssue #124-2
January 9, 2013

If the authors of the recent article “Campbell, Iridium, and the Future of Valuation Litigation” are looking for any more support for their thesis that market evidence—not “paid litigation experts”—should determine company values in bankruptcy, then they’re going to be reading a new case very closely.

Citing dueling experts who begin with the same cash projections but end with values nearly $8 million apart for a relatively small, family-owned company, the federal bankruptcy court (N.D. Ill.) says the “wide” and “striking” disparity between experts “lends credibility to the concept that the DCF method is subject to manipulation and should be validated by other approaches.” In particular, it repeats the warning in Iridium that by using the malleable DCF, “a skilled practitioner can come up with just about any value he wants.”

In this case, the experts’ disagreement largely came down to how each calculated the weighted average cost of capital (WACC) under a CAPM approach, which in turn devolved on their treatment of three inputs—the debt-to-equity ratio, the equity risk premium (ERP), and the size premium—as well as the terminal value. To defend their points, each expert cited Ibbotson’s, Professor Aswath Damodaran, and the Gordon Growth model versus an exit multiple approach. But “each expert generally selected parameters that pushed his valuation in the direction he wanted to go,” the court says. In particular, both overstated the ERP, and both should have used the geometric, rather than the arithmetic, mean.

In the end, the court essentially fell back on “real world” evidence at the time of the company’s acquisition to find that it was solvent, including its lack of debt, its substantial cash in excess of working capital, and its ability to keep current on accounts payable. Read the complete digest of In re Bachrach Clothing, Inc., 2012 Bankr. LEXIS 4807 (Oct. 10, 2012) in the January 2013 Business Valuation Update; the bankruptcy court’s decision is posted at BVLaw.

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