Assessing a ‘Modern’ DCF Valuation

Factors to Consider When Evaluating a ‘Modern’ DCF Valuation

This article from Global Arbitration Review was first published December 19th, 2022. The entire article is available at https://globalarbitrationreview.com/guide/the-guide-damages-in-international-arbitration/5th-edition/article/assessing-modern-dcf-valuation

FTI Consulting’s Stuart Amor, Jose Alzate and Thomas Maassen authored a chapter for the fifth edition of the Global Arbitration Review’s “The Guide to Damages in International Arbitration” on the factors to consider when evaluating a ‘Modern’ DCF valuation.

The ‘Modern’ DCF valuation approach has been discussed in academic circles since the 1960s and is also known as the ‘certainty equivalent’ DCF. In this approach, the cash flows are first adjusted for risk to estimate ‘certainty equivalent’ cash flows. These cash flows are then discounted at the risk free rate. This is different from the standard DCF approach, where the risk is reflected in the discount rate through a risk premium.

This approach has gained interest after 2019 Tethyan Copper Company v Pakistan award, in which the Tribunal awarded USD 4.1 billion based on a ‘Modern’ DCF valuation.

The authors explain that one approach to estimating certainty equivalent cash flows is to use prices of futures contracts to account of pricing risk. This is difficult in practice, however, as futures markets further into the future are illiquid and futures markets do not exist for all risks.

The authors further explain that the evidence that the ‘Modern’ DCF approach is used by market participants is, at best, limited, which is relevant for certain standards of value, such as market value.

Reproduced with permission from Law Business Research Ltd.