Economic Damages: Lost Profit v Lost Value

Introduction

In an economic damages claim which is the appropriate measurement? Lost profit or lost business value? What is the difference and how are they calculated? This article explores issues addressed by the expert in an economic damages claim.

Lost Profit

Lost profits calculations are often used when the business or part of the business continues, but the business suffers a reduction in earnings. The economic damages are calculated for the period up until the business is restored to the position it would have been if the alleged damaging act hadn’t occurred.

Lost Value

Lost business value tends to apply where a business or part of a business ceases permanently as a result of the alleged act. The value of a business is the current, net present value of an earnings stream in perpetuity or for the life of the business.

Lost Profit v Lost Value

The key difference between a loss of profit calculation and a loss of business value is the period. Whether the earnings were damaged for a limited specific period (loss of profits calculation) or earnings are damaged for the life of the business (loss of value calculation).

That does not mean that the methods are mutually exclusive. There could be an instance where the plaintiff continued struggling with the business (loss of profits) but the business eventually folded (loss of business value).

Care needs to take though not to double count. In theory, the present value of any claim of lost profits cannot exceed the value of the business at the date of the loss.

Approach

In both calculations, the two key pieces of information requiring judgement by the expert are the earnings base and the discount rate. The discount rate and earnings base may be different in a loss of profit calculation to a loss of business value calculation.

Approaches for calculating the earnings base, include:

  • comparing the plaintiff’s earnings before and after the damaging act, or
  • comparing the plaintiff’s earnings after the damaging act to a comparable company or benchmark

Assumptions

Assumptions need to be made about what direction the earnings would have taken, but for the act. Were earnings prior to the act trending up or down?

Were there any other factors, apart from the act, that would have impacted earnings after the act? For example, was there a change in the industry, was there more or less competition, slower or faster economic growth? Was anything done by the plaintiff to mitigate losses?

Consideration also needs to be given to the period of trading prior to the act. How long had the business been trading? How well established and consistent were the earnings prior to the act?

With regards to the discount factor needs to reflect the risk of the earnings. Evidence for relevant discount factors might include comparable company information and comparable transactions. The discount factor needs to be relevant to the earnings base.

Conclusion

Calculating economic damages is not a clear cut approach.  Care needs to be taken that the appropriate approach is taken and that relevant and appropriate earnings and discount rate are used.

Further reading

About the author

Simon Cook, Valuations, Forensic Accounting, Virtual CFO. CA Accredited Business Valuation expert, Chartered Accountant and Certified Fraud ExaminerSimon is a CA Accredited Business Valuer, Chartered Accountant, and a Certified Fraud Examiner. Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice.  He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to the massive Bernie Madoff Ponzi scheme.

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