BVD-November-2008 Final 11-12 08

The Canadian Institute of
Chartered Business Valuators
Business Valuation Digest

Volume 14, Issue 2 November 2008
In this Issue
The Market Approach
and the Impact of Business
Combination Accounting
Rules ...................................................1
Practical Approach for
Incorporating the Notion
of Growth in the Evaluation
of the Cost of Capital....................9
E-Discovery Primer for
Chartered Business Valuators. 14
Estimating Economic
Damages in a Patent
Infringement Analysis............... 17
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BVD-November 2008.indd 1
The Market Approach and

the Impact of Business
Combination Accounting Rules
By Pter Harbula
Abstract
The implementation of SFAS 141 and IFRS is
not only a step towards fair value accounting
but also has an impact on the financial statements. The amortization charge of intangible
assets has a direct profit and loss statement
impact to be considered when performing the market approach. The subsequent
analysis aims to illustrate the distortion
that the new accounting rules can cause on
the way multiples are computed and what
adjustment are necessary if we want to apply
them consistently between companies with
different capital structures.
1. Introduction
The introduction of SFAS 141/142 and subsequent IFRS business combination accounting rules has shaped the business valuation
profession in many ways in recent years.
These rules have a constant impact on the
way the market approach can be applied.
The comparability of accounting policies has
already been a challenge when performing
a valuation within an international context
or with guideline companies listed in other
countries than the subject company. The latest evolutions of accounting rules have again
changed the landscape. While the objective
of fair value accounting is to make financial statements more in line with investors
expectations, these new rules also have an
effect on the way the business valuation professionals look at these financial statements
1.
as new challenges have arisen in the application process of the market approach.
The implementation of new accounting rules
for business combinations under US GAAP
(SFAS 141) as well as under the International Financial Reporting Standards (IFRS
3) have changed the way we now look at
goodwill and intangible assets in the balance sheets. Goodwill is no longer subject to
amortization but to impairment tests. Even
more importantly, the purchase accounting
process in business combinations results in
the recognition of intangible assets being
recognized in the balance sheets and amortized over their remaining useful life. In
a certain way, the amortization of goodwill
has been traded-off against the amortization
of intangible assets.
These accounting rules have significantly
changed the asset structure of balance
sheets, earnings profi le and volatility of
corporations subject to an intense M&A
activity. For example, in France as of end
2005, approximately 40% of the consolidated
shareholders equity of the French groups
in the CAC 40 index is composed of intangibles assets and goodwill, even after the
significant impairment campaign that led
to record asset write-downs during the years
2001 and 2002.1 In Germany, intangible assets (including goodwill) account for about
30% of the total balance sheet of the DAX 30
index corporations and a similar figure of
32% is reported for the United Kingdom for
Vivendi Universal has written down assets for 16 billion and France Tlcom for 10 billion at almost the same
time when AOLTimeWarner recorded an impairment loss of $54 billion.
11/12/08 9:58:45 AM
the FTSE non financial 100 index corporations. In general,

intangible assets have become a significant item in the balance sheet in the last decade and should be subject to closer
scrutiny of business valuation professionals in at least in
two aspects: financial ratio analysis and valuation multiple
computations.
When we compare, for the purpose of valuing with the
market approach, companies that have taken different paths
in their growth, unless we adjust for distortions induced by
accounting rules, the computed multiples will be distorted.
Hence, the resulting valuation conclusions could be erroneous for all multiples that are computed on financial drivers
that are considered after amortization expenses.
In the following sections, we highlight this effect through
an analysis of the business combination related accounting
rules.
'BJSWBMVFBDDPVOUJOHBOEOBODJBM
ratio analysis
New accounting rules related to business combinations
are interesting to valuation people as they have an impact
on the comparability of different companies, especially
when we make a comparison between companies that are
engaged in M&A operations versus corporations that have

not been proceeding to external growth recently. In this
context, we will not address the issue of financial instruments (SFAS 133 / IAS 32 / IAS 39) and the way they are
accounted for in the balance sheet and the profit & loss
statements, as this would probably warrant a separate
analysis (and a great deal of accounting rules explanation
too). We only focus our attention on the impact of accounting rules directly linked with the accounting treatment of
business combinations.
Some companies will proceed to acquisitions and manage growth through a series of steps that will shape their
financial statements differently as if the same company had
pursued an organic growth strategy. Should accounting
rules and their translation in financial statements have an
impact on the way we compute valuation multiples?
To illustrate the issue, let us take a simple example:
Company Y has performed a series of acquisitions recently
to reach its current status with sales of $1000 for an EBIT
of $190. Company X only experienced organic growth
and reached sales of $1000 since it has no intangible assets
related amortization expenses, its EBIT reaches $200.
Table 1: Ratio analysis

Company X
Company Y
Balance sheet
Intangible assets and goodwill
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
0
1000
500
1500
500
1000
Balance sheet
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
200
800
500
1500
500
1000
P&L
Sales
EBITA
Amortization expenses
EBIT
Financial expenses
Tax @ 40%
Net income
Net income before amortization
1000
200
0
200
-25
-70
105
105
P&L
Sales
EBITA
EBIT
Financial expenses
Tax @ 40%
Net income
Net income before amortization
1000
200
-10
190
-25
-66
99
105
Ratio analysis
ROCE (pre-tax)
Sales / Capital Employed
Working Capital / Sales
EBITA margin
EBIT margin
Net margin
Net margin before amortization
13,3%
0,67x
0,5x
20,0%
20,0%
10,5%
10,5%
Ratio analysis
ROCE (pre-tax)
EBITA margin
EBIT margin
Net margin
Net margin before amortization
13,3%
0,67x
0,5x
20,0%
19,0%
9,9%
10,5%
Page 2 Business Valuation Digest November 2008
11/12/08 9:58:46 AM
Let us now compare the key financial ratios of the two

companies. The two companies offer identical asset turnover ratios (sales / capital employed, working capital / sales).
Company X record and operating margin of 20%, seemingly
above the 19% recorded by Company Y. If we consider an operating income driver before amortization expense (EBITA),
the two companies have the same operating profitability. In a
similar way, if we compare the Return On Capital Employed
(ROCE) of these companies without subtracting the amortization expense related to a business combination, both
firms would have the same ROCE of 13.3%.
Based upon the limited facts offered above and if we
consider these companies prior to the amortization of
intangible assets, is there any reason, based upon the facts
presented herein, that these companies should have different business (enterprise) values? They offer similar operating ratios and hence we should consider, ceteris paribus,
that they should have the same Market Value of Capital
Employed.2
Should managements decisions between organic and external growth have an influence on the business (enterprise)
valuation parameters if, by any relevant ratios, the two com-
panies have similar business and financial characteristics?

Holding all else equal, Company X and Company Y should
have the same value of Invested Capital under the market
approach, since they are virtually identical in all respects
expect the investment path they have followed (organic
growth versus external growth).
3. Amortization of intangible and valuation

multiples: a numerical example
The easiest way to see the potential distortion caused by the
amortization charge related to the purchase accounting of
historical business combinations is to consider a numerical
example.
Let us consider the valuation of a Subject Company where
we have found two potential guideline companies that perfectly match in terms of business comparability, financial
ratios, and other key qualitative factors. The only difference
relates to the treatment of intangible assets in their balance
sheet and we know that for both of them, these intangible
assets were capitalized through purchase accounting in
recent business acquisitions.3
Table 2: Subject company and peer group : unadjusted multiples

Subject Company
Comparable 2
Balance sheet
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
0
1000
500
1500
500
1000
Balance sheet
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
200
1800
1000
3000
1000
2000
Balance sheet
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
200
800
500
1500
500
1000
P&L
Sales
EBITA
EBIT
Financial expenses
Tax @ 40%
Net income
1000
200
0
200
-25
-70
105
P&L
Sales
EBITA
EBIT
Financial expenses
Tax @ 40%
Net income
2000
400
-50
350
-50
-120
180
P&L
Sales
EBITA
EBIT
Financial expenses
Tax @ 40%
Net income
1000
200
-20
180
-25
-62
93
Ratio analysis
ROCE (pre-tax)
Market value of equity
Market value of invested capital
Valuation multiples
2.
3.
Comparable 1
13,3%
0,67x
0,5x
??
??
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x

3000
4000

2000
2500
MVIC / EBIT
P/E
11,4x
16,7x
MVIC / EBIT
P/E
13,9x
21,5x
This approach is correct for the market approach and not the tax shield related to the amortization of the intangible asset.
For simplification purposes, we assume that the various discounts and premiums both offset each other in this case.
Volume 14, Issue 2 Page 3
11/12/08 9:58:46 AM
Applying the multiples derived from the sample to the Subject Company, we obtain the following valuation results:
Table 3: Valuation results with unadjusted multiples

Valuation analysis
Drivers
Average sample multiples
Market value of
Invested Capital
Market value of Equity
EBIT
200
MVIC / EBIT
12,7x
2532
2032
Net income
105
P/E
19,1x
2504
2004
Market value of the equity of the Subjet Company
2004 - 2032
We obtain a value of Invested Capital between $2,504 and

$2,532 (rounded), which results in an Equity Value comprised between $2,004 and $2,032 (rounded). This means
that the Invested Capital of the Subject Company is worth
more than the Invested Capital of Company 2.The overstatement arises due to the failure to the failure to adjust
EBIT by adding back amortization expense associated with
a previous business combination.
Let us now analyze the case where we adjust the financial drivers of both Comparable 1 and Comparable 2 for
amortization expenses to see whether we can eliminate this
suspected distortion. In this second approach, we adjust P
/ E and MVIC / EBIT multiples4 for amortization expenses
in the denominator and still assume that the various discounts and premiums both offset each other.
Table 4: Subject company and peer group : adjusted multiples

Subject Company
Comparable 1
Comparable 2
Balance sheet
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
0
1000
500
1500
500
1000
Balance sheet
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
200
1800
1000
3000
1000
2000
Balance sheet
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
200
800
500
1500
500
1000
P&L
Sales
EBITA
EBIT
Financial expenses
Tax @ 40%
Net income
1000
200
0
200
-25
-70
105
P&L
Sales
EBITA
EBIT
Financial expenses
Tax @ 40%
Net income
2000
400
-50
350
-50
-120
180
P&L
Sales
EBITA
EBIT
Financial expenses
Tax @ 40%
Net income
1000
200
-20
180
-25
-62
93
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x

Valuation multiples
??
??
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x

3000
4000

2000
2500
MVIC / EBITA
Adj. P/E
10,0x
14,3x
MVIC / EBITA
Adj. P/E
12,5x
19,0x
4. Hence we use a MVIC / EBITA multiple.
11/12/08 9:58:47 AM
Applying the valuation multiples computed prior to amortization expenses, we obtain the following results:
Table 5: Valuation results with adjusted multiples

Valuation analysis
Drivers
Market value of
Invested Capital
Market value of
Equity
EBITA
200
MVIC / EBITA
11,3x
2250
1750
Adj. Net Income
105
adj. P/E
16,7x
2250
1750

Valuation analysis
Drivers
1750
Market value of
Invested Capital
Market value of
Equity
EBITA
200
MVIC / EBITA
12,5x
2500
2000
Adj. Net Income
105
adj. P/E
19,0x
2500
2000
1750
Applying this second approach, we find that the Subject

Company has an Invested Capital value of $2,250 (rounded), which results in an Equity Value of $1,750 (rounded).5
Would we have only applied Comparable 2, we would have
obtained the same Value for Invested Capital and Equity as
the one that is mentioned for Comparable 2, since they post
the same cash earnings, regardless of the amortization
expenses.6 Therefore, we can conclude that $1,750 is the
correct answer for the value of the Subject Company and
have thus seen that a distortion is introduced when not adjusting the valuation multiples for amortization expenses.
If we adjust for this inconsistency, we obtain however the
correct results.
5.
6.
4. R&D expenses and valuation multiples: another

numerical example on a similar issue
The same route we have considered for intangible assets acquired in a business combination can of course also be applied to a case when we compare companies that capitalize
intangible assets versus companies that expenses the costs
or when companies use different useful life for amortizing
intangible assets.
Let us look at the valuation of a Subject Company where we
have found two potential guideline companies that perfectly match in terms of business comparability, financial
ratios, and other key qualitative factors. The only difference
relates to the treatment of intangible assets in their balance
sheet (capitalization versus expensing).
The adjusted net income is computed by adjusted the reported net income by the amortization expense, net of the tax shield effect. It should be noted that
not all.
The distortion with the results yielded with the average sample multiples stems from the fact that Company 1 (for unexplained reasons) has lower multiples
than Company 2. There are a number of reasons that could explain such as a situation, but this is outside the scope of this article.
11/12/08 9:58:47 AM
Table 6: Diverging R&D policy between the subject company and the peer group: unadjusted multiples
Subject Company
Company 1
Comparable 2
Balance sheet
Capitalized R&D
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
100
0
900
500
1500
500
1000
Balance sheet
Capitalized R&D
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
0
100
1900
1000
3000
1000
2000
Balance sheet
Capitalized R&D
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
125
75
800
500
1500
500
1000
P&L
Sales
R&D expensed
EBITA
R&D amortization
EBIT
Financial expenses
Tax @ 40%
Net income
1000
50
200
0
0
200
-25
-70
105
P&L
Sales
R&D expensed
EBITA
R&D amortization
EBIT
Financial expenses
Tax @ 40%
Net income
2000
0
400
0
-100
300
-50
-100
150
P&L
Sales
R&D expensed
EBITA
R&D amortization
EBIT
Financial expenses
Tax @ 40%
Net income
1000
0
200
0
-50
150
-25
-50
75
Ratio analysis
ROCE (pre-tax)
R&D investment (% of sales)
13,3%
0,67x
0,5x
5%
??
??
Valuation multiples
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x
5%
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x
5%

3000
4000

2000
2500
MVIC / EBIT
P/E
13,3x
20,0x
MVIC / EBIT
P/E
16,7x
26,7x
Applying the multiples derived from the sample to the Subject Company, we obtain the following valuation results:
Table 7: Diverging R&D policy between the subject company and the peer group: Valuation results with unadjusted
multiples
Valuation analysis
Drivers
Market value of
Invested Capital
EBIT
200
MVIC / EBIT
15,0x
3000
2500
Adj. Net Income
105
P/E
23,3x
2950
2450

Valuation analysis
Drivers
2450 - 2500
Comparable 1
Market value of
Invested Capital
EBIT
200
MVIC / EBIT
13,3x
2667
2167
Adj. Net Income
105
P/E
20,0x
2600
2100

Valuation analysis
Drivers
2100 - 2167
Comparable 2
Market value of
Invested Capital
EBIT
200
MVIC / EBIT
16,7x
3333
2833
Adj. Net Income
105
P/E
26,7x
3300
2800
2800 - 2833
11/12/08 9:58:48 AM
We obtain a value of Invested Capital between $2,950 and

$3,000 (rounded), which results in an Equity Value comprised between $2,450 and $2,500 (rounded). This means
that the Invested Capital of the Subject Company is worth
more than the Invested Capital of Company 2. We can
also see that if we would have applied only Company 1 or
Company 2 as a guideline, we would have obtained very
different results for both Invested Capital ($2,600 to $3,333)

and Equity Value ($2,100 - $2,833).
If we adjust the financial drivers of both Comparable 1 and
Comparable 2 for amortization expenses as well as the P /
E and MVIC / EBIT multiples7, we obtain results that are
more consistent:
Table 8: Diverging R&D policy between the subject company and the peer group: adjusted multiples
Subject Company
Company 1
Balance sheet
Capitalized R&D
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
100
0
900
500
1500
500
1000
Balance sheet
Capitalized R&D
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
0
100
1900
1000
3000
1000
2000
Balance sheet
Capitalized R&D
Tangible assets
Working Capital
Capital Employed
Net financial debt
Net equity
125
75
800
500
1500
500
1000
P&L
Sales
R&D expensed
EBITA
R&D amortization
EBIT
Financial expenses
Tax @ 40%
Net income
1000
50
200
0
0
200
-25
-70
105
P&L
Sales
R&D expensed
EBITA
R&D amortization
EBIT
Financial expenses
Tax @ 40%
Net income
2000
0
400
0
-100
300
-50
-100
150
P&L
Sales
R&D expensed
EBITA
R&D amortization
EBIT
Financial expenses
Tax @ 40%
Net income
1000
0
200
0
-50
150
-25
-50
75
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x
5%

Valuation multiples
7.
Comparable 2
??
??
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x
5%
Ratio analysis
ROCE (pre-tax)
13,3%
0,67x
0,5x
5%

3000
4000

2000
2500
MVIC / EBITA
P/E excl. Amortization
10,0x
14,3x
MVIC / EBITA
P/E excl. Amortization
12,5x
19,0x
Hence we use a MVIC / EBITA multiple.
11/12/08 9:58:48 AM
Table 9: Diverging R&D policy between the subject company and the peer group: Valuation results with adjusted
multiples
Valuation analysis
Drivers
Market value of
Invested Capital
EBITA
200
MVIC / EBITA
11,3x
2250
1750
Adj. Net Income
105
adj. P/E
16,7x
2250
1750

Valuation analysis
Drivers
1750
Comparable 2
Market value of
Invested Capital
EBITA
200
MVIC / EBITA
12,5x
2500
2000
Adj. Net Income
105
adj. P/E
19,0x
2500
2000
Applying this second approach, we find that the Subject

Company has an Invested Capital value of $2,250 (rounded), which results in an Equity Value of $1,750 (rounded).9
Would we have only used Comparable 2 as a guideline
company, we would have obtained an Invested Capital value of $2,500 and an Equity Value of $2,000, which means
that the Subject Company would have the same value as
Comparable 2. This would seem consistent as they post the
same cash earning.
5. Conclusions and further thoughts

As we can see, there are potential distortions introduced
by accounting into the computation process of valuation
multiples that should be properly accounted for and identified when applying the market approach, especially when
comparing companies with different growth histories and
profiles. This is even more an issue in todays booming
M&A environment when comparing small or medium
enterprises to large, listed corporate groups for whom acquisition and external growth is part of every days life.
The main reason why amortization expenses linked to
business combination accounting should be excluded from
the computation scheme of valuation multiples is that it
does not represent an economic expense but it is only an
accounting entry in the books that should not influence
the value of a business. We should all be aware that the
reasons why these accounting rules on business combinations make the consolidated financials often less meaningful or useful for valuation perspectives are that (1) there are
significant biases in estimating whether some intangible
assets should be recognized or not and what methodology
should be applied and (2) that there are some areas in the
valuation of intangible assets that are highly judgemental
and might lead to differences in areas like useful life estimation, attrition rate / survivor curve analysis, etc
9.
2000
In addition, despite efforts for explaining transactions

or acquisitions performed by listed groups to investors,
it is nevertheless often made difficult to understand the
real synergy potential in a specific business combination.
Thus, the resulting goodwill in the balance sheet can be
the reflection of many different things. Therefore, potential
impairment charges are also difficult to understand and
explain from an economic point of view. Since impairment
charges are non-recurring in nature and represent a oneoff extraordinary item, therefore they should be treated the
same way as we consider amortization expenses and subject to restatement in the financial drivers for computing
the valuation multiples. Moreover, such logic should also
apply for the intangible asset related amortization expenses
when there is a potential indication that discrepancies
might exist between the subject company and the guideline
companies.
In a broader sense, of course, a similar rationale as outlined above needs to be applied when we compare companies in different countries and / or using different accounting rules. Even if we compare companies using the same
accounting principles, a part of the valuation analysis is to
understand the different option retained. As illustrated,
the earnings of a company that expenses its entire R&D
may need to be adjusted when applying valuation multiples
of firms that capitalize and amortize their R&D.
There is a more important issue, beyond the valuation multiple computation. Beneath the surface of these new rules for
business combinations is also a need to reshape the corporate communication scheme of large corporations, especially for those that perform acquisitions on a regular basis.
These corporations should abandon using net earnings
or operating income as their primary vector for financial
communication, as these drivers can very easily be affected
by the acquisition policy through the amortization expense
The adjusted net income is computed by adjusted the reported net income by the amortization expense, net of the tax shield effect. It should be noted that
not all.
11/12/08 9:58:49 AM
of intangible assets. Value creating deals could be perceived

negatively by investors just because they seem dilutive in the
short term on accounting results. In this respect, financial
investors need to become more aware and the valuation
professionals need to do their share of the job
In conclusion, when computing valuation multiples, given
the recent tendencies in accounting rules and especially regarding instruments and their impact on financial income,
expenses or shareholders equity, a more cash-based view
is necessary to compute meaningful multiples that should
be applicable between the different types of companies.
Offsetting different accounting policies and making companies more comparable, or bringing accounting based
figures closer to economic realities have always been a
part of the valuation process. However, looking at recent
changes in the US and international accounting rules, one
might wonder whether they are making the job any easier
to us? While this all becomes more complicated, what a
tremendous business opportunity this represents for the
valuation profession!
This article was originally published in the Business
Valuation Review. 26.1 (2007).
Practical Approach for Incorporating

the Notion of Growth in the Evaluation
of the Cost of Capital
By Robert Schulz
'BDVMUE"ENJOJTUSBUJPO 6OJWFSTJUEF4IFSCSPPLF
Abstract
A practical approach is given for evaluating the growth
rate g used in business evaluations. The method uses a
two-stage model and is based on the determination of an
effective growth rate using company projections usually
found in the business plan and the expected long term
growth of the economy.
Introduction
All methods of evaluation of the equity value of a company
on a going concern basis require the estimation of a representative net cash flow or net benefit and an appropriate
capitalization rate. A capitalization rate is the rate of return
used to convert estimated maintainable discretionary cash
flow to present value. The equity value is usually written in
the following way:
Vt =
CFt+1
tcap
CFt+1
kg
(1)
double counting when considering growth. Therefore, if the

numerator of equation (1) does not include any projected
growth except for inflation, CFt+1 can be estimated quite precisely based on past financial performances of the company.
The cost of equity on the other hand, includes many
components. It must reflect the operational as well as the
financial risk of the company. An appropriate evaluation
of this term must take into account internal variables such
as the quality of the management team, the nature of the
tangible assets of the company as well as external variables
such as the growth rate of the economy, the interest rate,
the state of the competition etc.
Determination of the discount rate

The built up method [1] is often used to evaluate an appropriate cost of equity. According to this method, the cost of
equity is given by:
k = R f + (R m R f ) + RPs + ( -1) (R m R f ) + RPu
Where Vt is the equity value of an enterprise at time t, CF

is a representative net cash flow, k is the cost of equity or
the discount rate and g is the expected growth rate of the
cash flow being discounted. The capitalization rate is derived when a growth factor is deducted from the discount
rate. There is an inherent assumption that the cash flow
that is capitalized will be generated to perpetuity.
When using equation (1), it is important not to include
any growth term into the representative net cash flow if
g represents the total expected growth of the cash flow of
the company in the future. In other words, we must avoid
(2)
R f is the risk free rate normally taken as the rate on long

term government bonds (typically 10 years) which includes
an inflation rate based on a consumer price index. The
inflation rate included in the risk free rate must be consistent with the inflation assumptions considered in the cash
flow projections. Where inflation has been excluded from
forecasted cash flows, it should also be excluded from the
discount rate. R m R f is the long term risk premium of
the equity markets over the risk free rate. It is calculated
from the historical return on common stocks. Ibbotson &
Associates give mean values for this rate of return based on
the Standard & Poors (S&P) 500 Index or the TSE Index
11/12/08 9:58:49 AM
[2]. RPs is a business specific risk factor associated with

the size of the company. It is usually referred to as a size
premium. Values for the size premium are given according
to company market capitalizations [2]. is the covariance
between the returns associated with a particular industry
and those of the total market portfolio. It is a measure of
stock price volatility relative to the overall market index. =1 for the market as a whole. If >1, the industry is
considered riskier than the overall market. Therefore ( -1)
(R m R f ) is the risk premium of the industry over the long
term risk premium of the equity market. Industry premium estimates are usually listed based on industry SIC
codes [2].
company specific circumstances, the growth factor normally is comprised of the expected long term inflation, and
may incorporate an incremental real growth rate. Where
expected real growth has been reflected in the estimate of
maintainable discretionary cash flows, that same growth
should not be accounted for again in the capitalization
rate.
Finally RPu is the specific risk associated with the company.

It is the non systematic risk. Contrary to all previous rates
which can easily be defined, the company specific risk must
be determined after a careful analysis of the strength and
weaknesses of the company in relation to competition. The
business specific (or internal) risk factors are those particular to a business not accounted for in the assessment of the
industry risk factors. An adjustment in the rate of return
may be required where a business faces more or less risk
than does its related industry in general. Business specific risk factors other than size that should be considered
includes: management depth, key personnel, products and
services offered, R&D efforts and patent portfolio, plant
facilities and state of the equipments, labor force, contracts,
customer dependence, ability to react to change, the degree
of diversification, historic operating results and projections,
fixed to variable cost ratio, product life cycles, underlying
net tangible assets etc.
Determination of the growth factor G called

Effective Growth Rate
The actualisation rate or the cost of equity k can be

calculated using equation 2 once all of the previous rates of
return have been defined.
The last step in the evaluation of the capitalization rate
and the equity value of a company consists of estimating
the growth rate g. Depending on industry-specific and
As mentioned before, we believe it is best to use only the

maintainable nominal discretionary cash flow without any
growth term in the numerator of equation 1 since it can
easily be determined and include all growth considerations
in the g factor.
The real growth rate deducted from the discount rate to

determine the capitalization rate should be a long term average growth rate. Theoretically, it is required to be steady
into perpetuity. Where real growth in cash flows from
operations is anticipated, perpetual annual increases in
both net trade working capital and growth related working
capital expenditures normally are required to support the
long term real growth assumption. Because of this projection to infinity, total growth cannot depart too far form
inflation plus population growth.
Typical business plans forecast discretionary cash flow for
a given number of years (typically five to seven). This can
be considered as the company expected growth rate over
this period of time. After that, it is difficult to estimate
growth. Should we consider the long term expected growth
rate of the associated industry or the expected long term
growth rate of the economy?
In this paper, we propose a practical approach to calculate
an effective growth valid into perpetuity which combines
the medium term (five to seven years) forecast of the company being evaluated and the long term expected growth
of the economy.
11/12/08 9:58:49 AM
Figure 1: Discretionary cash flow growth model and effective growth rate.
Effective growth rate G(k, g, N, ge) to perpetuity
1
k-G
1-
(1+g)
(1+k)
N
+
N-1
(1+g) (1+ge )
k-g
(1+k)
-N
(3)
(k ge )
g
Economy e
Cash Flow
m
Co
ny
pa
Company expected
growth
growth ra
Effective
Years
Figure 1 shows the model. In the first N years over
which
the business plan of the company is defined, the discretionary cash flow is growing at a rate g expected from
the companys business plan. After this period of time, we
assume that the growth rate of the discretionary cash flow
will follow the growth of the economy ge. Based on the
values of g, N, ge and the cost of equity k determined
from eq. 2, it is possible to calculate using equation 3, an
effective growth rate G (k, g, N, ge) valid to infinity. The
right end side of equation 3 shows the present value of the
series of cash flows shown in Fig.1 discounted at a rate k.
The left end side is written as 1/(k-G) in order to be able
to use the effective growth rate G directly into an equity
value formula.
te G
Economy expected
growth
According to this model, it is now possible to calculate

precisely the effective growth rate to use in the equity value
formula (equation 1), knowing the company business plan
and their forecasts and the long term expected growth of
the economy. This effective growth rate G depends on
the company expected growth of their cash flows over the
period of N years defined in the business plan, the long
term expected growth of the economy and the corresponding discount rate to be applied.
Table 1 shows an example of the calculation of the effective
growth rate as a function of
11/12/08 9:58:49 AM
Table 1: Effective growth rate G (k, g, ge, N)
11/12/08 9:58:50 AM
The discount rate and the companys expected growth rate

over a period of five years assuming an economy growth
rate of 2,7%. We see in Table 1, that if a company expects to
grow at a rate of 15% over the next five years, the effective
growth rate to be used in the equity evaluation of this company is 7.08% for a discount rate of 18% if the long term
expected growth of the economy is 2.70%.
Conclusion
The valuation of the equity value of a company requires the
determination of a number of variables such as a representative net cash flow (CF), a discount rate (k) and an expected growth rate (g) of the cash flow. The representative net
cash flow assumed to be generated to perpetuity, can easily
be determined based on companys performances if no
growth is taken into consideration. Moreover, if the built
up method is used to evaluate the discount rate, all rates of
return associated with equation 2 can be determined quite
easily based on tables available in the literature except for
the company specific risk (the non-systematic risk). In this
case, a detailed study of the company position within the
industry should be conducted and a rate premium typically
between 0 and 5% should be added or subtracted to the
overall rate of return depending on whether the company
performs better or worst than the average company in the
industry. Finally, an effective growth factor of the cash
flow valid to infinity should be determined. Which growth
factor should be used (the long term growth of the company estimated by the management team, the long term
estimated growth of the industry or the growth rate of the
economy)? In the past, there was no practical approach to
address such problem. In this paper, we propose to use a
two stage model where in the first stage we consider the expected growth of the cash flow found in the business plan
of the company (g) over the forecasted period (N) (typically
five to seven years) and in the second stage, we consider
the long term expected growth rate of the economy (ge).
This allows us to calculate an effective growth rate which
depends on g, N, ge and the discount rate k. This effective
rate can then be used in the equity value formula (equation
1) to estimate the en bloc fair market value of the outstanding shares of the company.
Note: Tables such as the one shown in Table 1 for various
values of g, k, N and ge are available from the author.
Contact e-mails: Robert Schulz: schulz.robert@ireq.ca ; Fernand Gurin: Fernand.Guerin@USherbrooke.ca .
Acknowledgments
The author would like to thank Professor F. Guerin from
University of Sherbrooke for helpful discussions regarding
this novel practical approach.
References
[1] Shannon Pratt, The Cost of Capital, second edition,
2002, editor Wiley & Sons Inc.
[2] Ibbotson Associates, Valuation Edition and Cost of

Capital, last editions.
This article was originally published in the Business
Valuation Review. 25:4 (2006).
11/12/08 9:58:50 AM
E-Discovery1 Primer for Chartered Business

Valuators
By Matt Diskin and Tae Kim
Documentary Discovery
Documentary Discovery in the Electronic Age
The theory behind the discovery process in civil litigation

is that each side gets the opportunity to know the other
sides evidence. This is a timely and complicated process,
because parties are required to disclose, with few narrow
exceptions, all relevant information and documentation.
The upshot of this process is that most disputes settle when
all the facts are on the table.
Traditionally documentary discovery was a fairly straightforward task. Counsel would meet with his or her clients
and generally identify the key people that were involved in
the facts relating to the claim. Each of these individuals is
asked to gather all relevant documents and counsel would
compile and review them in formulating the Affidavit of
Documents. It is in this context that the rules of discovery
were formulated; however, recent technological advances
have had a significant impact on the way that organizations deal with information and documents. The modern
world generates far more documentation than ever
before, and this has necessarily impacted the way that litigators undertake the documentary disclosure exercise. In
todays world, litigators must consider electronic discovery
or e-discovery as it has some to be known when dealing
with electronic sources of information and documentation for litigation.
There are two major components to the discovery process.

First is the documentary production stage, and second
is the oral discovery phase. During the first stage, both
parties disclose the relevant documents they have in their
power, possession or control.
The term document has been given a very broad meaning under Ontarios Rules of Civil Procedure. It includes
such things as correspondence, internal memoranda,
memos to file, diary entries, handwritten notes, rough
notes, agreements, invoices, telegrams, bills, notes, securities, vouchers, sound recordings, video tapes, films,
photographs, charts, graphs, maps, plans, surveys, books
of accounts and information stored or recorded in a computer, or on a disk, tape, or other devices.
The courts also take a broad approach to relevance in this
context. Any document that may bear a semblance of relevance to any of the issues in the lawsuit is considered to
be relevant and must be produced. Relevant documents are
not to be limited to those that are helpful or to those which
are intended to be used as part of one partys case.
The parties to a lawsuit are required to list all relevant
documents in a sworn Affidavit of Documents. In that
document, a representative of each party swears that they
have made a diligent search of records and that all documentation relevant to the litigation has been listed. The
opposing litigant is then entitled to make copies of these
documents at their own expense.
1.
Electronic information is different than paper information: it is far more voluminous, easily deleted, sometimes
recoverable and potentially more costly to review and may
contain private or privileged information. Identifying the
varied sources of electronic information can be a challenge
in itself. In addition to a users computer, relevant information can be found on other less obvious places such as
servers, removable media (e.g. CDs, DVDs, floppies), portable devices (e.g. USB thumbdrives, iPods, external hard
drives), communication devices (e.g. Blackberry, PDA,
smart phones), and backup tapes. All of these sources can
be found in the custody of the litigants or with external
third parties such as internet service providers or off-site
storage/hosting facilities.
Even after the potential sources of the relevant information
have been identified, there are further issues and challenges based on the type and format of the information. These
challenges are illustrated with the following questions:
This article refers mainly to legislation and practice in Ontario although reference is also made to the Sedona Canada Working Group which covers
all of Canada.
11/12/08 9:58:50 AM
t "SFPOMZUIFBDUJWFMFTSFMFWBOUPSJTBGVMMGPSFOTJD
analysis required (i.e. deleted information)?
anticipated relevance and probative value of the evidence

being sought.
t *TUIFSFMFWBOUJOGPSNBUJPOJOBOBDDFTTJCMFGPSNBU PS
are additional steps required to access the information?
(e.g. outdated backup software, encrypted information,
legacy accounting system)
Despite this general rule, when undertaking documentary

disclosure one should consider whether generation of a
new document that did not exist prior to litigation from
an electronic database makes sense (i.e. a report from an
accounting database.). This may be prompted by a request
from the other side, or it may simply be a good way to
present information in a useful manner. Often, helpful
evidence can be extracted. Moreover, during the oral phase
of discovery the opposing party will be entitled to obtain
through discovery questions whatever relevant information or documents are contained in electronic records.
Hence, the generation of a responsive document is often
the most efficient way to address these types of questions.
If, at an early stage, the parties can be clear about the
information they need, then the litigation process can be
effectively streamlined and simplified
t *TMFNFUBEBUBJNQPSUBOU FHDSFBUJPOEBUF NPEJFE

date, author, etc.)
t *TUIFSFQSJWJMFHFE QFSTPOBM PSDPOEFOUJBMCVUOPU
relevant information that needs to be separated before
production for litigation from any of the different
sources?
Depending on what information is required for litigation
and in what media it is stored, the format of electronic
information can also add significantly to the overall cost of
production.
While the traditional methodology for undertaking documentary discovery still applies, the challenges created by
technology have resulted in a judicial attitude of proportionality when it comes to the disclosure and production of
electronic information. Courts are becoming more mindful of the effort, time and cost required to be incurred,
relative to the benefits. The Sedona Canada Working
Group (WG7) has recently released the final version of the
Sedona Canada Principles governing electronic discovery
(the Sedona Group was originally a U.S. based think tank
developing best practices and guidelines for managing
electronic discovery). In addition, the Ontario Bar Association Discovery Task Force also produced E-discovery
Guidelines that were influenced by the work of the original
US Sedona Group.
Courts are deferring to the Sedona Canada Principles with
increasing frequency. One recent appeal dealt with what
might be considered the core principle of proportionality.
For example, Vector Transportation Services Inc. v. Traffic
Tech Inc. et al., Justice Perell quoted widely from the Sedona Canada Principles, and observed that the innovations
of technology combined with the ingenuity of advocates
can yield an infinite class of information that might satisfy
the test of a semblance of relevancy.
Generally, a partys production obligation does not normally require it to create documents. This request often
comes up when a database may contain relevant information, but reproduction of the database is impractical or impossible (e.g. customer relationship management system).
The court can make an order that a litigant produce new
documentation (e.g. generate reports from a database), but
such an order is discretionary and the court will analyze
how onerous the request is, and balance that against the
Technology to Assist Review of Electronic

Documents
It may seem that the use of technology has simply added to
the complexity of litigation in the discovery phase; however technology is also part of the solution. There are many
service providers that assist in the collection, sorting,
review and production of electronic documents, some by
using innovative technologies as discussed below.
The use of technology is also not a new concept for many
law firms. Many have been using document management
applications to assist in the discovery phase and trial
preparation for well over a decade now. Years ago, lawyers
recognized the benefits of taking hardcopy documents and
digitizing them by scanning the documents and pairing
the scanned images with a searchable database. Technologies like OCR (optical character recognition) came into use
to take the content of the physical document into a digital
form to make it electronically searchable and ultimately
reduce the volume of non-responsive documents for the
producing party to review.
Technology currently used in e-discovery is based on
the same concept as the document management systems
for digitized hard copy documents, essentially electronic
documents are linked to a searchable database. Since most
current hard copy documents originated in a digital form,
it was only a matter of time before the electronic source
documents were sought as a part of discovery. E-discovery
focuses on preserving the original source of documents
(computers, disks, servers, tapes, etc.) and culling down
the non-relevant information (which can be very voluminous with electronic sources).
11/12/08 9:58:50 AM
The rapid growth of the technology services industry related to e-discovery has produced some very powerful tools
for assisting counsel and their clients in sifting through the
enormous quantities of electronic information common to
litigation today. Some technologies focus on the culling of
documents by eliminating de-duplication2, so that when
identical electronic documents are identified, counsel only
has to review the document once. Other technologies assist
counsel in the review stage using techniques like clustering (grouping documents with similar content) or concept
searching (identifying documents that might have a relationship to key documents even if it does not exactly match
search parameters).
&YQFSU8JUOFTTFT3PMFJO%JTDPWFSZ
With the proliferation of digital information, the documents requested during discovery can come in many
forms and large volumes. As a result, experts (such as
Chartered Business Valuators) are being called upon more
often to assist counsel in processing, reviewing, and organizing this information to identify and highlight salient
facts, particularly when the subject at the heart of the
litigation involves valuation or other specialized expertise.
The increased significance placed on electronic documents
has expanded the role of the expert in their ability to assist
counsel. Now the expert must be familiar enough with
e-discovery concepts and be in a position to understand the
clients obligations and ability to produce relevant information during discovery. An expert should also be able to recognize when a computer forensics expert or an e-discovery
vendor is required to assist in accessing the information
that they need for their own work, and they should have a
working understanding of the operative legal framework.
Chartered Business Valuators may be called on to act as
experts in either a consultative or testifying role. Best
practices dictate that counsel be in contact with potential
experts early on. Doing so earlier rather than later enables
the expert to communicate what data and information he
or she needs to best address the questions posed to provide
an opinion. In turn, this may shape the evidence that is
provided as part of discovery and the scope of relevance in
documentary disclosure. For example, an expert may be
able to inform counsel early on what data is relevant for the
analysis that will ultimately be performed, despite the appearance on its face otherwise. Counsel should work with
experts to make sure that the ultimate testifying expert gets
the right data early on to support the experts report.
Early consultation with counsel can also be helpful in
structuring and detailing the oral discovery of the other
side. Knowing what information the expert wishes to
review enables counsel to conduct a more efficient and
effective oral examination of the opposing party and get
undertakings to provide information needed. Experts can
2.
add tremendous value during examination of the opposing

party, if he or she can also advise about potential electronic
sources of evidence that the opposing party may have in
their control.
&YQFSU8JUOFTTFT8PSLJOH1BQFST
Experts should bear in mind the capacity in which they
have been retained. If an expert is not going to present a
report and testify (a consulting expert) his or her notes and
working papers may be protected by litigation privilege
and will not be subject to disclosure to the other side. The
situation is quite different for an expert retained for the
purpose of providing testimony. As soon as the experts
report is delivered (as is generally required before trial), any
documentation that the expert created or received during
the course of his or her retainer will likely be required to
be disclosed to the opposing counsel on its request. This
means that testimonial experts should be very careful
about what documents, including electronic documents,
they produce. Computer forensic techniques can be used to
resurrect old drafts and opinionated emails. Some counsel
often requests a preliminary review and oral opinion before
anything is committed to paper. In other instances, counsel
may also seek to work with the expert while he or she drafts
the report to ensure that clear language that would assist
the court is used and to minimize or avoid the exchanging
of drafts.
Civil Justice Reform Project

On November 20, 2007 Ontario Justice Coulter Osborne
issued his Summary of Findings and Recommendations of
the Civil Justice Reform Project to the Attorney General of
Ontario. His report focused on reform of the civil justice
system to make it more accessible and affordable thus
enhancing access to justice for Ontarians. The discovery
phase of litigation, in most cases, is the most expensive
component of litigation. Given the additional expenses
associated with e-discovery, Justice Osborne had specific
recommendations with respect to e-discovery.
The report encouraged use of the Ontario Bar Association Discovery Task Forces E-discovery Guidelines and
the Sedona Canada Principles through a Practice Direction. Justice Osborne suggests that this could be achieved
through the courts refusing to grant discovery relief or
appropriate cost awards on a discovery motion where
parties have not considered the E-discovery Guidelines or
Sedona Canada Principles. Justice Osborne also recommended that the Civil Rules Committee consider ways to
more fully incorporate e-discovery concepts in the Rules of
Civil Procedure, similar to the direction being taken in the
United States.
De-duplication is the automated process of eliminating identical documents using specialized software to improve the efficiency of review by reducing
redundancy.
11/12/08 9:58:50 AM
8IBUUIF'VUVSF.BZ)PME
The attention that electronic evidence has received from the
Canadian legal community demonstrates the importance
it will play in the future of litigation in Canada. Likewise,
the valuator needs to seriously consider e-discovery and
the guidelines developed by the legal community to deal
with it; the guidelines have implications relating to what
foundational material is ultimately available to the valuator, both as a consulting expert and a testifying expert. As
these guidelines, are put into practice, case law will further
clarify how e-discovery is carried out and how this will
further affect the role of the expert.
As technology plays a greater role in litigation today, the

valuator needs to become more familiar with e-discovery
concepts and the available solutions. The valuator that can
identify situations when to involve additional experts to
deal with electronic evidence (and the right kind of expertise) will be in a better position to assist their clients.
Matt Diskin is an Associate at Heenan Blaikie and Tae Kim, is
an Associate Director at Navigant Consulting.
Estimating Economic Damages in a Patent

Infringement Analysis
By Craig A. Jacobson
The issues of patent valuation and economic damages analysis have become more prevalent as intellectual property has
become more recognized as a significant component of total
corporate value. The large settlements and damage awards
in several recent patent litigations exemplify how important
intellectual property has become to many corporations. This
discussion explains methods of estimating damages where
intellectual property is infringed upon. It is important for
corporate managers to obtain both professional legal advice
and competent financial advice in order to effectively manage patent-related issues.
Introduction
As the U.S. economy continues to evolve, the total business
assets of the typical corporation are increasingly comprised
of intangible assets. The most important intangible assets
of a company are usually intellectual property. Intellectual
property assets include patents, copyrights, trademarks,
and trade secrets.
By nature, corporate intellectual property is more difficult to identify, value, and manage compared to corporate
tangible assets. While many elements of valuation and
damages calculation are relevant to intellectual property in
general, this discussion will focus on estimating damages
related to patent infringement.
The importance of properly managing patents has been
highlighted in several highly publicized patent disputes.
The most notable dispute was between (1) Research In Motion (RIM), the company that makes the popular BlackBerry wireless device, and (2) a company named NTP Inc.,
which claimed that RIM improperly used a patent owned
by NTP. This litigation resulted in a settlement of over $600

million.
The large size of many recent settlements related to patent
litigation highlights the importance of understanding the
analysis of economic damages in a patent infringement
litigation.
In the past, in many patent infringement cases, judicial
decisions awarded reasonably low royalty rates. This result
contrasts with the results of many recent cases, in which either damages have been awarded, or a settlement has been
reached, in amounts that are substantially greater than a
reasonable royalty payment would indicate.
Another reason for the increased importance of patent
analysis is that there are remedies beyond damages, such as
an injunction. An injunction entitles a patent holder to stop
the sale of infringing products.
The existence of an injunction can dramatically change
the negotiating parity of companies involved in settlement
discussions related to alleged patent infringement. This was
the case in the litigation between RIM and NTP. In that
matter, the ultimate settlement was significantly greater
than amounts the companies had discussed prior to the
possibility of NTP obtaining an injunction.
This discussion will focus on issues related to patent valuation issues and estimating damages in a patent infringement. These issues are important to business owners and
their professional advisers. This is because understanding issues related to patent valuation will enable business
owners to make better decisions in managing these assets,
including the issue of whether to litigate in the case of pat-
11/12/08 9:58:50 AM
ent infringements, or the response to defending allegations

of patent infringement.
methods. There are three generally accepted valuation

methods applied to patents:
One result of the increased dollar amounts associated with

patent litigation is that more companies are taking steps to
catalog and enforce proper use of their patents. This trend
has resulted in a general increase in revenue from licensing
patents.
1. Incremental income methods. These methods attempt

to quantify one or both of (a) increased revenues associated with the subject patent and/or (b) decreased
expenses associated with the subject patent.
The incremental income method compares expected
revenue and expenses with and without the use of the
subject patent. Several revenue measures may be affected by the subject patent, including unit sales, price
per unit, market share, and number of customers.
Another relevant factor related to patents is the fact that

many observers believe that the current patent protection
system is both outdated and overburdened. There have been
several recent patent litigations where the alleged infringer
claims that a patent that has already been issued will not
ultimately hold up.
The legal and technical aspects of patents are beyond the
scope of this discussion. However, it is important to consider this factor along with other issues when faced with
patent litigation.
-FHBM'SBNFXPSL
Damages in patent infringement cases are provided by
statute 35 U.S.C. Section 284. This statute reads in pertinent part:
Upon finding for the claimant the court shall award
damages adequate to compensate for the infringement, but in no event less than a reasonable royalty
for the use made of the invention by the infringer,
together with interests and costs as fixed by the
court.
When the damages are not found by a jury, the court
shall assess them. In either event the court may
increase the damages up to three times the amount
found or assessed.
The court may receive expert testimony as an aid
to the determination of damages or of what royalty
would be reasonable under the circumstances.
The holder of a patent that has been infringed is entitled to
one or both of:
1. lost profits from sales that the patent holder would have
made but for the infringement and/or
2. the payment of a reasonable royalty on sales of the infringer that depended on the infringed patent.
These infringement damages are known as compensatory
damages.
In addition, if the infringer is found to have willfully infringed the subject patent, the patent holder may be entitled
to triple damages, known as punitive damages.
The list of expense measures that can be affected is

significantly longer. A representative sample of these
expense measures includes reduced cost of goods sold,
reduced operating expenses, increased production levels, and decreased labor-related expense.
2
Profit split methods. A profit split analysis allocates a

measure of economic income and assigns it to the subject patent. The starting point in a profit split analysis is
the total income of the economic unit that uses the subject patent. The income is then split among the subject
patent and the other factors that contribute to generating the total income of the economic unit.
These factors include:
a. the companys tangible assets and intangible assets
and
b. other expenses incurred in the production of the
good that incorporates the subject patent.
3. Royalty income methods. Royalty rate analyses relate to

one of two analytical scenarios:
a. royalty income that the patent holder earned or
could earn by licensing the patent to an outside
party and
b. royalty expense that is not paid to an outside party
because the owner of the patent can avoid this
expense by way of owning the patent.
The underlying principal behind the determination of a
reasonable royalty rate is that the estimated reasonable
royalty rate represents a reasonable measure of the royalty rate that would have resulted from an arms- length
negotiation between the parties.
In the case of the patent licensor, this royalty rate represents payments that the patent licensor would be willing
to pay and still make a reasonable profit on products
covered by the patent.
Patent Valuation Methods
Estimating Patent Damages
Many calculations of patent infringement damages are

based on one or more generally accepted patent valuation
The goal of a patent damages analysis is to replicate what

would have occurred but for the alleged patent infringement. In other words, what would the financial position of
11/12/08 9:58:50 AM
the patent holder have been if no infringement had taken

place? The existence of lost profits in a but for scenario
assumes that the patent holder and the infringer produce
products that compete with one another.
The most basic calculation of lost profits equals the number

of additional units that the patent holder would have sold
times the profit per unit. A more precise calculation of lost
profits should consider many other interrelated factors.
As discussed above, there are two measures of patent damages: lost profits and reasonable royalty. Each of these two
measures is discussed below.
These lost profit factors include:
-PTU1SPUTPO-PTU4BMFT
A lost profits analysis measures the additional profits the
patent holder would have received but for the alleged
patent infringement. At the outset, it must be determined
whether the patent holder did in fact lose profits due to patent infringement. There are a number of tests that determine the appropriateness of lost profits damages in patent
litigation. The most common is known as the Panduit
four-part test.1
Under the Panduit test, the patent holder must prove:
1. demand for the patented product,
2. the absence of acceptable noninfringing alternatives,
3. the patent holders capacity to produce the product and
fulfill any demand, and
4. the profits the patent holder would have made.
It is important to note that the first three factors address
the issue of causation, involving proof that the patent
infringement directly caused actual lost sales and/or profits
by the patent holder. The Panduit four-part test addresses
the presumption that there would have been greater profits
but for the alleged infringement.
The factors that aid in the determination of whether the patent holder lost profits depend on the facts and circumstances
of the parties and products involved. For example, in a twosupplier market, the first two factors can often be inferred:
1. there is already evidence of demand for the patented
product and
t 7PMVNFFSPTJPOSFFDUJOHMPXFSTBMFTPGQSPEVDUTPS
services that either were made or could have been made
by the patent holder as a result of the patent infringement. Volume erosion estimates can be based on calculations of either absolute sales volume or market share.
t 1SJDFFSPTJPOSFFDUJOHMPXFSTBMFQSJDFTGPSQSPEVDUT
or services of the patent holder that were caused by the
patent infringement. Factors that should be considered
in estimating price erosion include:
1. the relative prices of products sold by the parties,
2. changes in overall prices for the product caused by
the entry of an additional participant in the market
for the product, and
3. lower sales growth caused by the distractions and
expense of litigation related to the subject patent.
The extent of volume erosion and price erosion in turn
depends on a number of factors, including (1) demand
for the affected product(s) and (2) the number of market
participants. For example, in a market with only two
participants, it is likely that the patent holder would
have received most of the sales actually made by the patent infringer.
t 1SPEVDUFSPTJPOUIFFOUSZPGBOFXQSPEVDUJOUPUIF
market can have a detrimental effect on the reputation
of the product in general.
When this new product infringes the subject patent, this
factor can negatively impact the reputation of products
in general in the relevant market segment and, therefore, can cause lower sales and profits of products made
by the patent holder.
2. there are no acceptable noninfringing alternatives.
Reasonable Royalty
Proof of the third factor (the patent holders capacity to

produce the product) does not require that the patent
holder have excess production capacity. Proof of capacity
can include alternatives such as:
A royalty rate estimate based on market comparable royalty

rate transactions will often indicate a minimum royalty
rate for litigation purposes. This is because the court may
grant damages that are greater than a reasonable royalty
rate in order to deter infringement.
1. the availability of financing and other resources that

would have enabled production or
2. the possibility of either a joint venture or outsourcing
production.
Once the patent holder has proved that there is a reasonable probability that the lost sales would have been made,
a calculation of lost profits can be undertaken. It is important to note that while lost profits can rarely be calculated
precisely, the calculation of lost profits should contain a
sufficient level of support that the calculation cannot be
considered speculative.
A reasonable royalty rate can be estimated using an analytic approach. The goal of an analytic approach is also to
estimate the royalty rate that would have been agreed upon
in an arms-length transaction.
A royalty rate analyses represents one of two scenarios:
1. royalty income that is actually earned or hypothetically
could be earned by the patent holder, and
2. the savings to the patent infringer from not paying a
reasonable royalty to the patent holder.
11/12/08 9:58:50 AM
The starting point for a royalty rate analysis is the profits

earned by the infringer on products that use the subject
patent. The goal of a royalty rate analysis is to attribute a
portion of the profits to the subject patent.
It is common in estimating patent royalty rates or patent
economic damages to utilize a combination of the above
methods. The combination of valuation methods used will
reflect the myriad of factors that must be considered in
patent valuation. For example, in estimating the income of
a product using the subject patent, it may be assumed that
a portion of the economic income of the subject product is
generated by the products brand name.
As is the case in many valuation and/or damages related issues, the best indication of a reasonable royalty rate is often
similar market transactions. If it can be determined that
there have been royalty rate agreements that were (1) agreed
to on an arms-length basis and (2) represent a reasonable
basis of comparison to the subject patent, the market royalty rate is a good starting point for estimating a reasonable
royalty on the subject patent.
If there are several market comparable royalties, the analyst
can then adjust the reasonable royalty rate to account for
estimates of differences between (1) the subject patent and
(2) the market comparable patents.
An important consideration in using market comparable
royalty rate transactions is that the terms of the royalty
rate agreements must be similar to those that the infringer
would have faced in order to avoid infringement. A royalty
rate for a license that is granted in order to avoid litigation
is not considered a market comparable royalty rate.
The determination of damages can rely on one or both of
the methods discussed above, and are dependent on the
specifics of the situation. For example, in the following two
hypothetical examples, in can be argued that the patent
holder did not suffer any lost profits as a result of the patent
infringement, and that a reasonable royalty is an appropriate damage measure:
1. A company that produces radios inadvertently infringes
a patent held by another radio producer for one of the
parts of its radio products. There exist numerous substitute patents for this same process that the infringer
could have used. Therefore, the patent holder may not
have lost any sales or profits due to the infringement.
2. The same radio producer infringes a patent held by a
company that does not make any products that compete
with the infringers radio products. Here, it may also be
inferred that the patent holder did not lose any sales or
profits due to the infringement.
Consider an alternative scenario in which the patent holder
has developed a patent that:
2. has no substitute. In other words, the subject patent is a

game changer for this type of radio.
If the competing company were to infringe this patent, the
calculation of damages might consider both lost profits and
a reasonable royalty. In the case of lost profits, it may be
proven that the patent holder:
1. had lower sales of radios than they would have received
absent the infringement and
2. sold radios at a lower price because the infringement
allowed the marketing of a competing product.
In addition, the patent holder might be entitled to a reasonable royalty based on the profits of the infringer. In this
case, since (1) the profits per unit are presumably significantly greater than the profit per unit in the scenario from
the preceding paragraph and (2) the increase in profits is
largely attributable to the use of the infringed patent, then
the reasonable royalty for this patent (a patent with no substitute) would be significantly greater than the reasonable
royalty on the patent that does have substitutes.
In addition, the patent holder can be awarded interest on
lost profits and/or reasonable royalty from the time of
infringement through the date the award is paid. The patent holder can sometimes also be reimbursed for expenses
incurred in litigation related to patent infringement.
Summary and Conclusion

As intellectual properties, including patents, have become
increasingly important assets of many companies, the
importance of understanding and properly managing these
assets has increased. In order to maximize the value of
these assets, company management should receive expert
advice related to the valuation and calculation of economic
damages related to patents.
Note:
1. See Panduit Corp. v. Stahlin Brothers Fibre Works, 575
F.2d 1152 (6th Cir. 1978)..
Craig Jacobson is a senior manager in the New York City

and Westport, Connecticut, offices of Willamette Management Associates, a national business valuation, economic
analysis, and financial advisory services firm. Craig can be
reached at (646) 658-6231 in New York City, (203) 221-3412
in Westport, or at cajacobson@willamette.com. This article
originally appeared in the Summer 2006 issue of Willamette
Management Associates Insights. More information on
Willamette Management Associates may be found at
www.willamette.com.
This article was originally published in Insights. (Summer
2006).
1. makes the radio sound considerably better than without

using the subject patent and
11/12/08 9:58:50 AM

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The Canadian Institute of

Chartered Business Valuators

Business Valuation Digest

The Business Valuation Digest is the

The Market Approach and

the FTSE non financial 100 index corporations. In general,

engaged in M&A operations versus corporations that have

Table 1: Ratio analysis

Page 2 Business Valuation Digest November 2008

Let us now compare the key financial ratios of the two

panies have similar business and financial characteristics?

3. Amortization of intangible and valuation

Table 2: Subject company and peer group : unadjusted multiples

Market value of equity

Market value of equity

Volume 14, Issue 2 Page 3

Table 3: Valuation results with unadjusted multiples

Average sample multiples

Market value of Equity

Market value of the equity of the Subjet Company

We obtain a value of Invested Capital between $2,504 and

Table 4: Subject company and peer group : adjusted multiples

Market value of equity

Market value of equity

Market value of equity

4. Hence we use a MVIC / EBITA multiple.

Page 4 Business Valuation Digest November 2008

Table 5: Valuation results with adjusted multiples

Average sample multiples

Adj. Net Income

Market value of the equity of the Subjet Company

Average sample multiples

Adj. Net Income

Market value of the equity of the Subjet Company

Applying this second approach, we find that the Subject

4. R&D expenses and valuation multiples: another

Volume 14, Issue 2 Page 5

Market value of equity

Market value of equity

Average sample multiples

Market value of Equity

Adj. Net Income

Market value of the equity of the Subjet Company

Market value of Equity

Adj. Net Income

Market value of the equity of the Subjet Company

Market value of Equity

Adj. Net Income

Market value of the equity of the Subjet Company

Page 6 Business Valuation Digest November 2008

We obtain a value of Invested Capital between $2,950 and

different results for both Invested Capital ($2,600 to $3,333)

Market value of equity

Market value of equity

Market value of equity

Hence we use a MVIC / EBITA multiple.

Volume 14, Issue 2 Page 7

Average sample multiples

Market value of Equity

Adj. Net Income

Market value of the equity of the Subjet Company

Market value of Equity

Adj. Net Income

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