Business valuation analysts are often called upon to calculate economic damages incurred when something goes wrong for a company or a shareholder. It might be a disruption in normal operations caused by a fire or flood, lost revenues caused by theft or breach of contract, or a business transaction gone bad.
The damages may be reflected in the loss of market value of a business or property, loss of cash flow, or straightforward lost earnings. The damage could be a one-time event or result in ongoing loss of revenue.
How can you measure “harm”? It can be difficult to isolate the effects of the harmful act, but for valuation analysts, this is essential to calculating economic damages.
There are various types of economic damage calculations, and which type to measure depends on the facts and circumstances of each case. Assessing lost profits is among the most common types of economic damage calculations.
In doing this type of work, valuation analysts work for both plaintiffs and defendants. They undertake this analysis on behalf of plaintiffs to estimate the loss caused by the act or on behalf of defendants to refute the plaintiff’s alleged damages.
Net Lost Profits
Lost profits are claimed over a certain period of time known as the “loss period,” which reflects the start and end of the loss. For obvious reasons, the length of this period is often a source of contention between the parties.
The amount of lost profits is determined by estimating the profits that what would have been earned during the loss period if the damaging act hadn’t occurred. These estimated revenues are then adjusted by the costs that would have been necessary to generate that revenue.
For example, if a manufacturing business closes for a period of time because of a faulty part provided by a vendor, the business would not be incurring certain costs such as sales commissions or production expenses during that downtime. These “unspent” monies would be deducted from the lost revenue amount.
In some cases, costs are added instead of subtracted. For example, if a company incurs excess costs for cleanup after a fire or pays an expert for social media cleanup due to a PR disaster, these costs would be added to the damage calculation.
Valuation analysts rely on a number of methodologies to measure lost profits. The following are among the most common:
Before and after: Using this method, analysts use the company’s actual figures from the loss period. They compare performance prior to the damaging event and after the damaging event, with the difference in performance between the two periods equaling the loss.
Yardstick: Also known as the “benchmark” method, this type of analysis compares the damaged company’s results during the loss period to the performance of similar companies during the same time period.
But for: Using this method, analysts calculate what the profits would have been “but for” the damaging act. Some believe that this method produces the most reliable results because it accounts for factors such as economic conditions, capital needs, and capacity.
Note that generally, the damaged party does its best to mitigate the damage and associated costs. For example, a manufacturing company would be expected to reduce the amount of incoming raw materials and associated costs during a production stoppage.
A Complicated Endeavor
Determining lost profits is a complicated process, and litigation typically raises the stakes for this type of work. Be sure to work with an experienced valuation analyst for a lost profits calculation so that he or she can present the calculation in court as an expert witness if need be.