Michael B. Lehner, CPA/ABV, CFE, ASA
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MLehner@zbtcpa.com
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DCF business valuation method is only as good as what lies beneath

DCF business valuation

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The decision in the case In re Bachrach Clothing reminds us that the discounted cash flow (DCF) method is only as reliable as its underlying assumptions — and the objectivity of the experts performing the analyses.

Background

Bachrach Clothing, a 125-year-old men’s retailer, was sold to a private equity firm for $4 million cash and $4 million in subordinated debt in 2005. The PE firm structured the sale as a leveraged buyout (LBO), transferring stock to an affiliate entity and replacing the company’s board of directors.

The board appointed a new CEO, who made substantial changes to Bachrach’s operations. For example, she discounted inventory by $7 million, paid $2 million in dividends, wrote off $3 million in extraordinary expenses related to the LBO and continued to pay the PE firm $400,000 a month in management fees. These changes eroded Bachrach’s borrowing base from $4.3 million to $1.3 million.

Bachrach began experiencing cash flow shortages in early 2006. When the PE firm refused to contribute additional capital, the company filed for Chapter 11. A fraudulent conveyance lawsuit was filed against the former owners, alleging that Bachrach was insolvent at the time of sale.

Valuation discrepancies

Both sides’ valuation experts relied on the same cash flow projections and used the DCF method to value Bachrach on the LBO date. But their conclusions were more than $6 million apart. The bankruptcy court stated that “the disparity in their valuations is striking given that they relied on the same data as their starting point. It lends credibility to the concept that the DCF method is subject to manipulation.”

The primary source of the discrepancy was the way in which the experts determined the weighted average cost of capital (WACC), which was used to discount Bachrach’s cash flows to their net present value. The debtor’s expert used a 19.5% WACC and the seller’s expert used a 12.3% WACC. A lower WACC results in a higher value. The court commented that “each expert generally selected parameters that pushed his valuation in the direction he wanted to go.”

Elusive parameters

Some important points the court made in the 2012 ruling about the parameters underlying the WACC include:

Capital structure. The court recognized that the company’s low leverage and high borrowing capacity made it a valuable prospect in 2005. Therefore, the judge sided with the seller’s expert, who used Bachrach’s actual capital structure to derive his WACC.

Equity risk premium. The court opined that the geometric mean, rather than the historic mean, is appropriate when estimating the equity risk premium (a component of the cost of equity). After reading materials cited by both experts, the judge decided that the “arithmetic average return is likely to overstate the premium.”

Size premium. The court accepted the smaller size premium set forth by the seller’s expert, because that expert had considered industry-specific evidence to “inform” his decision about size. Specifically, the expert’s research revealed that smaller apparel shops tend to perform better than their larger counterparts, thereby warranting a lower size premium.

Hard lessons

Overall, the court decided that the seller’s expert provided “better reasoned” explanations for his DCF assumptions. Thus, his value of approximately $6 million was “more aligned with real world events or contemporaneous market data.”

The company had no long-term debt, was current on payables and held significant excess working capital in 2005. So, the court ruled that Bachrach was solvent on the LBO date.

Make no mistake, the court did not disregard the DCF method in its opinion. It remains a technically sound, widely used tool for valuing private business interests. But the case cautions business owners and experts that shortcuts and bias won’t lead to the desired result. Experienced valuators understand the need to support their assumptions with objective, market-derived evidence — as well as with sanity checks and other valuation approaches — in order to ensure a well-reasoned value conclusion that can withstand court scrutiny.

Michael Lehner


This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.