Are Judges and Experts Missing the Boat on the Use of the Capitalized Cash Flow Method

Judges and valuation professionals seem to be missing the boat on the proper application of the capitalized cash flow (CCF) method under the income approach. The method depends on the present value of the future cash flows of the business being valued. Since the CCF uses just one numerator and one denominator, the single-period cash flows represent the expected future cash flows. This seems to get lost on experts and thus often judges. An example of this is the recent Arizona appellate court divorce case Dawson v. Dawson.¹ The husband was awarded the parties’ business, Hospitality Construction Inc. (HCI), which provides construction services to hotels. HCI has only one customer, Good Nite Inc. (GNI). HCI does not have a contractor’s license but works off of GNI’s license.

GNI sold four hotels between August 2020 and August 2021 that provided significant revenues to HCI. As well, GNI stopped servicing three other GNI hotels in 2020. At both the trial court and appellate court levels, the dispute as to the value of HCI broke down into the application of the CCF methodology. The wife’s expert averaged the years 2019, 2020, and 2021 to determine the ongoing cash flows of HCI for the CCF. The husband’s expert determined the ongoing cash flows to be the 2021 cash flows. He argued that, with the sale of hotels and the end of construction at three other GNI hotels, the 2021 cash flows (the lowest of the three years the wife’s expert used) was more representative of future earnings.

Since we did not have the trial court’s decision nor copies of the experts' testimonies, we are to some extent speculating as to what was in their reports and testimony. However, it seems that perhaps neither expert made the specific argument that the cash flow amount they determined as the numerator for the CCF calculations took into account the pertinent point, i.e., that the expected cash flows that were used to determine the CCF cash flow numerator were intended to represent “expected future cash flows.”

As was indicated in the opinion in Dawson, the argument seemed to revolve around whether one year of cash flow instead of an average of several was sufficient to determine the value. The trial court came down on the side of several years being a more credible result than a single year in determining HCI’s value.

I see this happening more often recently. The number of years or periods to determine the single-period cash flows for use in the CCF is not relevant. The real issue is what are the future cash flows “expected” to be. If prior years are not truly representative of future cash flows, then they cannot be used to determine the single-period amount that is necessary in applying the CCF method. An example I often use is to assume that the best-selling drug of a pharmaceutical company had its patent expire at the end of the year for the valuation date. Since that drug would have a precipitous loss of revenue going forward, then the cash flows to be used in determining the value at the valuation date would not include the same levels of revenues in future years. So the history of earnings would not be of any value in determining the revenues going forward. To make this even more relatable to the Dawson case, assume we are doing the valuation a year after the expiration of the pharmaceutical company’s patent. We might conclude that the cash flows for the year just ended might be representative of the future cash flows.

The point is that, despite how you arrive at the single-period representation of future cash flows, it is important that you document your reasoning and present that to the court. In the Dawson case, it appears that neither expert really focused on that issue of “expected” cash flows. Had they, there might have been a different conclusion by the court.