Friday, 13 August 2021

Anyone purporting to be an expert should ensure their opinions are technically sound and based on a fulsome analysis rather than ‘junk science’.

‘Junk science’ is a term used to describe opinions or theories that on the surface seem to be well researched and scientific but in fact have little evidence to support them. A well-known proponent against junk science is best-selling author, John Grisham. Best known for his popular legal thrillers, he has sold over 350 million books world-wide. As a former lawyer, he also has a particular interest in the reforming of the criminal justice system in the USA, including reforms to laws associated with the death penalty, juvenile justice, wrongful convictions, mass incarceration and racism.
Mr Grisham has often expressed a belief that there are many innocent people imprisoned in the USA as a result of being wrongfully convicted.  In many interviews and in several of his books he has highlighted the role junk science played in their wrongful conviction, particularly in the period prior to the introduction of DNA testing. This junk science includes evidence of hair analysis, bloodstain patterns, fingerprints, arson, coerced confessions, gunshot residue and so on. This evidence, according to Mr Grisham, is and was often based on dubious analysis undertaken by so-called ‘experts’ – who he defines as people who attended seminars and workshops on forensics, smooth talkers with good vocabulary who have found it easy to convince judges that they ‘knew their stuff’. Once qualified as criminal forensic experts, he opines, they found it easier to convince unsophisticated jurors that their opinions were based on solid science.[1]
Whilst typically not involving jurors, the resolution of quantum in civil matters, such as contractual disputes and torts including misrepresentation and deceit, can often be largely dependent on the quality of expert evidence. In this context, it is evidence led by accountants and economists in claims for loss and damage and associated business valuation issues, that sometimes adopts approaches and assumptions which some might argue also fall into the category of ‘junk science’.
This paper examines some of those issues and the impact they have on quantum in dispute resolution of civil disputes. 

Discount rates used in valuing future cash flows

Although there is no formulaic or precise way to value businesses or the losses suffered by those businesses (or their owners) as a result of legal wrongs, there nevertheless remains a very strong theoretical basis for the assessment of the value of businesses and the calculation of losses suffered by businesses as a result of a legal wrong.
The assessment of business losses is focussed on the assessment, as at the time of the legal wrong, of the cash that would have been generated by the business in the future, and the proper discounting of the differences between those future cash flows to a present value at the valuation date using an appropriately risk-adjusted discount rate.
The estimation of future cash flows should be based on appropriate and supportable assumptions and should be ‘reconcilable’ with the historical results of the business. Essentially, this means that any difference between forecast revenues and profit margins and the trends apparent from historically reported revenue and margins of the business should be properly explained and rationalised.
The assessment  of an appropriate discount rate must also be supportable and expressed in terms consistent with the way in which the future cash flows are expressed. For example, discount rates should ideally be:

  1. expressed on a post-tax nominal basis where the future cash flows are expressed in post-tax nominal terms. Expert evidence should not include an incorrect mixing of post-tax and pre-tax concepts;
  2. applied to the future free cash flows generated by the business, rather than future profits or other ‘non-cash’ based measures. This is because it is theoretically incorrect to discount future profits – profits are an accounting concept and are not the same as cashflows; and
  3. calculated in accordance with the generally accepted standard framework, the Capital Asset Pricing Model (‘CAPM’), and appropriately cross-checked against the discount rates implied by the prices paid to acquire the same or similar businesses (using the cash-flow models prepared as part of that activity) at or around the valuation date where this information is available.

There are some general principles of CAPM that are often misunderstood and result in the incorrect calculation of discount rates. Those principles include the following:

  1. All inputs into CAPM should be based on long-term observations of those inputs, and not ‘spot’ observations. For example, the ‘de-levering’ (or ‘de-gearing’) of observed equity betas of comparable listed companies (‘peer group companies’), and the de-levering of the equity beta of the subject company if also listed, should be undertaken having regard to the long-term average capital structures (expressed as a percentage of debt and equity finance) of those companies and not the capital structure which existed at a point in time, such as the valuation date or a year-end date immediately prior to the valuation date (‘spot’ observations). Use of spot capital structures in this regard is an example of junk science;
  2. Similarly, the proportion of debt and equity used to calculate the weighted average cost of capital (commonly known as the ‘WACC’) should have regard to the long-term average capital structure of the peer group companies;
  3. All inputs into CAPM are only observable on a post-tax basis. Consequently, the application of CAPM results in a post-tax discount rate and the resultant discount rate should only be applied to post-tax cash flows;
  4. The discount rate calculated using CAPM cannot be converted into a pre-tax rate by simply ‘grossing up’ the post-tax rate by the tax rate. Some experts attempt to do this so that they can apply a discount rate to pre-tax cash flows. The equivalent pre-tax rate is correctly obtained by ‘back solving’ the discount rate that needs to be applied to forecast pre-tax cash flows to give the same answer as that obtained when the assessed post-tax rate is applied to forecast post-tax cash flows;
  5. When discounting cash flows in perpetuity, the selected risk-free rate for input into CAPM must be consistent with:
    1. i. the long-term growth assumption which underpins the perpetuity free cash flows used in the calculation of the terminal value of the business. Using the spot yield on a long-dated Government bond at the valuation date as a proxy for the risk-free rate would be another example of junk science if that yield was significantly less than the long-term growth rate underpinning the calculation of the terminal value of the business; and
    2. ii. the adopted equity market risk premium (‘EMRP’). Studies undertaken to evaluate the EMRP are based on long-term observations of market returns. Consequently, the proper matching of the risk-free rate with the selected EMRP requires consideration of long-term movements in the yields on Government bonds. Only where valuers are confident that the yield on Government bonds at the valuation date are reflective of expected long-term yields should the spot yields be adopted. Otherwise, some form of ‘normalisation’ should be undertaken (with appropriate support), whereby either the risk-free rate or EMRP is adjusted to reflect those long-term expectations.

It is also common for valuers to include adjustments to discount rates to reflect differences in the specific risks of the subject business relative to its peer group. Those valuers capture those adjustments in an ‘alpha’ factor included in the CAPM formula.  This approach, whilst common, is less than preferrable as it relies on professional judgement rather than objective data.

While it may be necessary to account for those matters in the valuation process, it is better valuation practice to capture those risks by an appropriate probability weighting of various cash flow scenarios which specifically recognise the cash flow impact of those risks.  

If discount rates are not calculated in accordance with the above principles, there is a significant risk of the over- or under-valuation of businesses and assets.
In the context of dispute resolution, fundamental mistakes made in the assessment of discount rates can lead to expert evidence falling into the category of junk science that is likely to be rejected by the court and result in protracted litigation and substantial additional cost to litigants.
In practice, experts will likely disagree on issues that are within their expertise, and there may be contrary views for a number of these points. Ultimately, what makes a 'good' expert is one who can properly explain and defend the basis of his or her opinions and the applicability to the specific circumstances of a matter. Otherwise their opinions are no better than ‘junk science’.


[1] ‘The Guardians’, John Grisham, Hodder and Stoughton, 2018, page 71