Present Value Analysis

When it is used

Present value analysis is used to express future lost earnings, lost household services, and future medical/non-medical care in a single lump sum for trial or settlement purposes.

Step-by-step

1. Project the nominal cash flow stream (wages, benefits, care costs) over the relevant horizon
2. Select a discount rate (often Treasury-based) matched to the horizon
3. Apply expected growth rates or a net discount rate to the projection
4. Compute the present value by discounting each period back to the valuation date
5. Document all assumptions so alternative calculations can be performed

Data sources

• U.S. Treasury yield curves
• BLS Employment Cost Index
• Historical wage growth series
• BLS Consumer Price Index, Medical Care component, for healthcare costs

Choosing the discount rate

The discount rate expresses what a dollar received in the future is worth today because a dollar in hand can be invested. Forensic economists generally draw it from the yields on United States Treasury securities, which carry no default risk, and match the maturity of the instruments to the horizon of the loss: shorter maturities for losses that end in a few years, a ladder of maturities or a long-term average for losses that run to retirement or to the end of life. The choice between the yields on the valuation date and a historical average is stated and justified in the report, because the two can differ and the difference moves the result.

Growth and the net discount rate

Future wages and future care costs do not stay flat. Wage growth is projected from the history of earnings for the occupation and the economy, using series such as the Employment Cost Index and the average wage indexes; medical costs are projected from the medical care component of the Consumer Price Index. When growth and discounting are applied together, the net discount rate, the difference between the two, is what determines the present value. A net rate near zero means that growth and the time value of money offset, and the present value approaches the simple sum of the losses stated in today's dollars; some jurisdictions adopt that offset by rule and the report follows the forum's approach where one is prescribed.

Reading a present value table

A present value schedule lists each future year, the nominal loss projected for that year after growth, the discount factor for that year, and the discounted amount, with the total at the foot of the table. Reading down the discount factor column shows how much of a distant year's loss survives discounting; reading across a year shows the effect of growth and discounting together. The schedule is prepared so that an alternative rate can be substituted and the table recomputed, which is how sensitivity analysis is presented.

Two errors recur in disputed calculations: discounting a stream that has already been stated in present dollars, which discounts twice, and growing a stream that was projected in real terms with a nominal rate, which grows twice. The report states whether each stream is in nominal or real terms and applies the matching rate.

Limitations

Results are sensitive to the discount rate, growth rate, and horizon assumptions. Sensitivity analysis is a standard practice in forensic economics.

Admissibility

Present value methodology is fundamental to forensic economics and well accepted (Jones & Laughlin Steel Corp. v. Pfeifer, 462 U.S. 523 (1983)). Disputes are typically over input choices rather than methodology.