The Present Value of Future Lost Profits, and the Time (excellent article)
National Association of Certified Valuators and Analysts
The Present Value of Future Lost Profits, and the Time Value of Money
Experts estimating the present value of a business’ future lost profits have much less direction
from the courts than their counterparts estimating the present value of a person’s lost earning
capacity. Professional literature has attempted to fill this gap providing many articles discussing
the differing methods for analyzing lost profits (e.g., yardstick, before-and-after, but for) or how to
determine the discount rate by applying a weighted cost of average capital, equity rates of return,
or some form of risk premium build-up. This article moves away from these others to address the
concept of the time value of money and how it applies to the discount rate applied to the future
lost profits.
Experts estimating the present value of a business’ future lost profits have much less direction from the
courts than their counterparts estimating the present value of a person’s lost earning capacity.
Professional literature has attempted to fill this gap providing many articles discussing the differing
methods for analyzing lost profits (e.g., yardstick, before-and-after, but for) or how to determine the
discount rate by applying a weighted cost of average capital, equity rates of return, or some form of risk
premium build-up.[1]
This article moves away from these others to address the concept of the time value of money and how it
applies to the discount rate applied to the future lost profits. The time value of money is a core principle of
finance. This concept should form the foundation for any discount rate to be used in estimating the
present value of future lost profits.
Two Step Process
There are two steps required for calculating the present value of future lost profits. The first is projecting
the cash flow that would have generated the lost profits. The second is determining the appropriate
discount rate to apply to the future lost profits. The total resulting from the application of the discount rate
to the future lost profits is the present value of these lost profits.
Robert Dunn and Everett Harry addressed this issue.[2] They argue the assessment of the discount rate
begins with the preparation of the spreadsheet estimating the lost sales less expenses associated with the
generation of those sales. The difference between these sales and costs are the lost profits. The level of
reasonable certainty may impact the discount rate used. They observe that: “[s]ome CPA experts project
the plaintiff’s hoped-for income stream, modify those losses to a realistic expectation by factoring in future
risks and then discount the adjusted future losses to a present value at a risk-reduced, relatively low
discount rate. Other experts project the hoped-for-but-lost amounts and then apply a higher discount rate
that already incorporates risk or uncertainty to determine present value.”[3]
Texas’ Appeals Courts have also addressed this issue. “The mere assertion that contracts were lost does
not demonstrate a reasonably certain objective determination of lost profits. [cite omitted] Whether
evidence is speculative or reasonably certain is a factual issue within the exclusive province of the jury to
determine. [cite omitted] Reasonably, certain lost profits may be proved by relying on such factors as: (1)
the experience of the business principals; (2) the nature of the business; (3) the nature of the market; (4)
the nature of the client base; (5) the sales force; (6) the marketing plan; and (7) the company’s track record
of sales. For example, when a business is already established and making a profit at the time the contract
was breached or the tort committed, pre-existing profit, together with other facts and circumstances, may
indicate with reasonable certainty the amount of lost profits. [cite omitted]”[4]
As the estimate of future sales and expenses may vary, so too the uncertainty or risk associated with the
calculation. For that reason, ‘Experts’ approaches to addressing risks or uncertainties can be very
different, however. Some CPA experts use discount rates that represent a return on U.S. government
securities or, alternatively, the cost of funds (interest on business loans) the plaintiff will face in the future.
The rates are applied to a reasonably predictable or risk-adjusted stream of lost profits—perhaps, for a
wrongful contract termination, to those of a contractor who has a clear, consistent history of profitability on
comparable projects. Others might use higher discount rates to arrive at present values when calculating
lost profits streams that have not been risk-adjusted.”[5]
Concept of Time Value of Money
The concept of the time value of money can be simply stated as the idea that money available at the
present time is worth more than the same amount in the future. “This core principle of finance holds that,
provided money can earn interest, any amount of money is worth more the sooner it is received.”[6]
This issue was addressed by the U.S. Supreme Court as early as 1916. “It is self-evident that a sum of
money in the hand is worth more than the like sum of money payable in the future.”[7] Based on
numerous federal and state court decisions, experts are expected to provide the present value of future
losses. This means that any future losses in personal and commercial damages cases must be reduced to
account for the time value of money.[8]
To make these calculations, experts apply a specified rate of return. The greater the discount rate (the
specified rate of return) the lesser the present value of the future losses.
In the Chesapeake case, the U.S. Supreme Court called for the use of a “safest and best” interest rate for
discounting personal income losses to present value. Other decisions have confirmed this position, calling
for the application of a “risk free” rate.[9]
Courts have not been as limiting in setting standards for the discount rate to be applied in commercial
damages cases. A review court cases shows that courts have accepted discount rates ranging from the
risk free rate to nearly forty percent. This makes the determination of the appropriate discount rate in a
commercial damages case controversial.
Discount Rates for Lost Profits
Commercial damages literature discusses three methods for determining the appropriate discount rate.
Safe rate of return;
Rate of return from investing the award; and
Rate of return commensurate with the risk in receiving the lost profits. [10]
The safe rate of return is seldom used for discounting for future lost profits. However, both federal and
state cases have allowed for such application. In the Northern Helix case, the appellant court upheld the
application of a discount rate “derived from currently available conservative investment instruments.”[11]
Texas appellant courts have also allowed the using of a safe rate of return stating, “The use of a risk-free
discount rate to calculate lost profits damages…was not erroneous as a matter of law.”[12]
The federal appellant court in the Energy Capital Corp. case noted, “The appropriate discount rate is a
question of fact.”[13] This decision goes on to discuss factors impacting the discount rate. “Energy Capital
argues that the sole purpose in discounting is to account for the time value of money. Again, we disagree.
When calculating the value of an anticipated cash flow stream pursuant to the discounted cash flow (DCF)
method, the discount rate performs two functions: (i) it accounts for the time value of money; and (ii) it
adjusts the value of the cash flow stream to account for risk.
We do not hold that in every case a risk-adjusted discount rate is required. Rather, we merely hold that
the appropriate discount rate is a question of fact. In a case where lost profits have been awarded, each
party may present evidence regarding the value of those profits, including the appropriate discount
rate.”[14]
Occasionally, this risk adjustment may reflect the rate of return the injured company may earn by investing
the court award. This method assumes the company will receive all of the future lost profits at one time
(as opposed to earning them over the period of recovery). Because the company received the lost profits
in a lump sum, they could be invested and earn money for the company during the recovery period.
Therefore, these future lost profits must be discounted by the rate of return the company will earn on these
lost profits during the recovery period to prevent overpaying the damaged party.
More commonly, experts determine a discount rate that is commensurate to the risk that would have been
assumed by the injured company to achieve the future lost profits. The greater the risk relating to the
company achieving the projected profits, under normal business circumstances, the greater the discount
rate. Many experts use a build-up method for determining this discount rate. The build-up begins with a
risk-free rate and adds various risk premiums that, when totaled, provide the discount rate. These risk
premiums may include market risk, financial risk, sales risk, product risk, and many others.[15]
Period of Recovery
One of the areas not receiving a great deal of notice in damages literature is the period of recovery for
calculating lost profits. The period of recovery is the number of days, months, or years over which the
injured company may claim lost profits. Some cases may be able to show losses for seventeen years (the
life of a patent) or ten years (the life of a trademark agreement), but most commercial damage cases will
have shorter loss periods.
Many contracts or agreements include notice periods allowing the parties to provide a notice and end their
relationship in a number of days. In some cases, courts have upheld these notices in breach of contract
matters shortening the recovery period to as short as thirty days.
Other cases have allowed companies to pursue recovery periods beyond the notice period. This is
particularly true when: “a termination in violation of a notice provision could have a severe impact on the
continuation of a well-established business and might include the loss of customer goodwill or damaged
customer relationships.”[16]
Time Value of Money, Recovery Period, and the Discount Rate
The length of the recovery period may directly affect the discount rate. This concept ties directly to the
time value of money. Traditionally, the longer the maturity before money will be received, the greater the
interest rate that needs to be paid on that money. This can be seen in a normal yield curve; the shorterterm
bonds provide lesser interest rates than bonds with longer maturities. As an example, below are the
yields for U.S. Treasury securities on November 17, 2015.
Maturity Yield
90 days 0.11%
180 days 0.33%
365 days 0.48%
2 years 0.86%
5 years 1.68%
10 years 2.29%
30 years 3.08%
These yields reflect the time value of money as reflected on a normal yield curve. [17]
The build-up method used to provide a risk adjusted discount rate calls for using the risk-free rate as its
base rate. This rate should vary depending on the recovery period. Using the November 17 data, if the
future recovery period is two years, the base for the build-up should be 0.86%. If the future loss is ten
years, the risk-free base would be 2.29%. That is a 143 basis points difference.
In addition, consider the risk premiums to be included in the build-up. The risk projecting cash flows over
the next two years with reasonable certainty should be less than assessing cash flows over ten years.
Conclusion
It is seldom that I have been involved in a matter where lost profits run more than five years into the
future. By using the date of trial as the date of measurement, a portion of the lost profits fall into the past
and are therefore, not discounted to present value. This division of the recovery period, naturally, reduces
the period for estimating future lost profits.
This article does not address using the date of trial (ex-post) or the date of injury (ex-ante) as the
measurement date for present value calculations. Unless required by the court, my practice assumes the
date of trial as the date of measurement. I, therefore, provide an ex-post present value calculation to the
court.[18]
Based on the time value of money, these shorter recovery periods should allow for lower discount rates. In
addition, the shorter recovery period should allow for less risk in projecting the loss. If a case included a
longer recovery period (ten years or more for patent or trademark infringement), greater discount rates
should reflect the additional risk in projecting the cash flow and the time value of money.
Many experts calculating lost profits come from a business valuation background. I have seen many
discount rates that reflect this. While a high discount rate is almost certainly appropriate for a business
valuation, it may not be appropriate for discounting lost profits. This is because discount rates are
expected to correlate with the reasonable certainty of the spreadsheet calculations. To project a twentyfive
to thirty percent discount rate for a recovery period of less than five years questions the
reasonableness of the projected cash flow and creates a sense of speculation with those calculations.
Because a business valuation calculation attempts to capture all of the future profits that would be
generated by the business, it is reasonable to assume high discount rates. This is also true in a business
destruction case where the business value captures all of the future lost profits at the time of the destroying
event. The capitalization rate (discount rate less a growth rate) used in this analysis would account for the
recovery period of the loss.[19]
With the business valuation capturing all of the company’s future profits, there is greater risk related to the
reasonable certainty of the cash flow analysis. For that reason alone, the discount rate would be greater,
and many cases, much greater, than the discount rate for a recovery period of less than five years. The
time value of money concept would support this difference.
Calculating the present value of future lost profits is a two-step process. During this first step of the
process, an expert will decide to adjust the projected cash flow figures for realistic expectations or leave
them in a hoped-for-but-lost format. This decision will impact the risk premiums to be included in the
discount rate. In the second step, the appropriate discount rate is determined. This discount rate will be
based on the reasonable certainty of the cash flow projections, the risks associated with the generation of
the estimated lost profits, and the period of recovery. In the end, the discount rate should reflect the facts
and figures relating to that specific case and the time value of money.
[1] These types of articles may be found on QuickRead by searching “Lost Profits”
[2] Modeling and Discounting Future Damages, Journal of Accountancy, Robert Dunn, Everett Harry,
January 2002
[3] Ibid, 1
[4] Toshiba Machine Co., America v. SPM Flow Control, Inc ., 180 S.W.3d 761, 777, (Tex. App. 2005)
[5] Dunn, Harry, 2
[6] Time Value of Money, www.investopedia.com
[7] Chesapeake & O.R. Co. v. Kelly, 241 U.S. 485, 489 (1916)
[8] States may have differing standards for discounting. An expert should always discuss the discounting
standards for a specific jurisdiction with attaining counsel prior to making a present value calculation.
[9] As example see Jones & Laughlin Steel Corp. v. Pfeifer, 462 U.S. 523 (1983)
[10] The Comprehensive Guide to Lost Profits and Other Commercial Damages, 3rd Ed, Nancy Fannon,
Jonathan Dunitz, BVR, 2014, Vol. 1, pages 346-354
[11] Northern Helex Co. v. U.S., 634 F.2d 557 (1980)
[12] Knox v. Taylor, 992 S.W.2d 40 (Tex. App. 1999)
[13] Energy Capital Corp. v. U.S., 302 F.3d 1314, 1333 (2002)
[14] Ibid. 1333
[15] For a more detailed list of the various systematic and unsystematic risks see Modeling and
Discounting Future Damages, Dunn, Harry, 2
[16] Mood v. Kronos Products, Inc., 245 S.W.3d 8, 13 (Tex. App. 2007)
[17] U.S. Bond and Market Rates, 11/17/2015, www.Bloomberg.com
[18] For discussion of this issue see Economic Damages: Discounting Concepts and Alternatives, Peter
Schulman, The Colorado Lawyer, 1999. 28, No. 1
[19] Recovery of Damages for Lost Profits, 6th Ed., Robert Dunn, Supplement September 2015, 219, 225
Allyn Needham, PhD, CEA, is a partner at Shipp, Needham & Durham, LLC, a Fort Worth-based litigation
support consulting expert services and economic research firm. Dr. Needham has been in the banking,
finance, and insurance industries for over 20 years. As an expert, he has testified on various matters
relating to commercial damages, personal damages, business bankruptcy and business valuation. Dr.
Needham has published articles in the area of financial economics and forensic economics and provided
continuing education presentations at professional economic, vocational rehabilitation and bar association
meetings. Dr. Needham can be reached at: (817) 348-0213, or by e-mail to:
aneedham@shippneedham.com.