Monday, March 9, 2009

Valuing Timberland V – The Discount Rate

This is the fifth and final post of a series on timberland valuation. If you missed the first post, which included an Overview plus a discussion on Disaggregation, you can read “Valuing Timberland I” here. The second post focused primarily on productivity and how that fits into today’s appraisal systems which use discounted cash flow techniques to determine the value of timberland. You can read “Valuing Timberland II” here. The third post focused on estimates of timber volumes and values, how we get them, and how to forecast them for future year’s cash flows. Read “Valuing Timberland III” here. The subject of the last post, Valuing Timberland IV, was on the methodologies used in discounted cash flow analysis. Today I’ll focus on the discount rate to be used in the cash flow model.

The “discount rate” is essentially the same thing as the interest rate used in any financial calculation. We have to get the series of future cash flows “discounted” back to the present so we pick the appropriate interest rate to do that. As an example, say you wanted to buy a tract of land and your credit union would lend you the money for 6%. You know there is some risk associated with this so you assign another 2% for risk. You would use a discount rate of 8%. Sounds simple to me.

Let me start off by saying “I don’t know what discount rate to use”! This question is argued by investors, economists and corporate finance types. But understand this, selection of the discount rate is the most important decision made during the valuation process. Let me illustrate.

Many years ago (I was working as a Land Acquisition Forester at the time) I decided to reread Thoreau’s “Walden” which led me to “In the Maine Woods”, “A Week on the Concord and Merrimack Rivers” and “Cape Cod”. Considering my job, Thoreau really got my attention with the following words from “Cape Cod”.

“Between the Pond and East Harbor Village there was an interesting plantation of pitch-pines, twenty or thirty acres in extent, like those which we had already seen from the stage. One who lived near said that the land was purchased by two men for a shilling or twenty-five cents an acre. Some is not considered worth writing a deed for.”

Thoreau had traveled across the Cape in the 1850’s and I had noticed and made mental note of these same pitch pine plantations while visiting there. So what would a Land Acquisition Forester think… “Man, what a buy that would have been!”

What if an investor knew what the values on the Cape would be like in 2008? Would he have bought some of that timberland for $0.25 acre? Maybe, maybe not. Let’s consider the opportunity and create a simple analysis. Let’s say that the investor could foresee all that wonderful HBU land on the Cape and actually KNEW what 2009 land prices would be like. Keeping it simple (so we can isolate the impact of discount rate selection), assume he leased the land out “for taxes” so he had no cash flows (positive or negative) other than the purchase and sale of the land. The data below shows the value of a $0.25/acre investment compounded forward for 150 years.






So…, would the investor have bought the land (for his descendents!!). It very clearly depends on the discount rate that the investor used. I don’t think that there is an acre of scraggly pine plantation on the Cape that could be bought for $1,562/acre and I doubt that you could sell an acre for over $300 million per acre either – not even the Kennedy compound. The value determined clearly depends on the discount rate used. So what discount rate would you have used? Think about that seriously. If the rate is too high (nice to get but will you get it!) you may never have the opportunity to make an investment EXCEPT one that is very risky.

When I was in forestry school (back in the 60’s) we normally used 6% in our forest economics courses. When I was an MBA student (in the late 70’s), we used the company’s marginal cost of capital with an appropriate adjustment for risk. Early in the timberland shift to TIMOs, it was pretty freely discussed that TIMOs were using real rates in the 6% to 8% which was based on the “risk free” rate of return (10 year T-bills at 4%) plus risk adjustment. At the same time, integrated forest products companies with large timberland acreages were using investment hurdle rates significantly above the average or even marginal cost of capital for the firm (a mistake – it should have been based on the marginal cost of capital and risk associated with purchasing and owning more timberland not riskier investments!). The result of this is that high-risk capital investments were subsidized by low-risk timberland ownership. As a general rule, discount rates used by the C corporations were much higher than that used by the TIMOs (rates in the range of 12% - 15% or more). Remember the decision you reached above with the Thoreau example. The C corporations also had to include taxes in the cash flow analyses (reducing cash flow and, subsequently, value) whereas most of the TIMO clients were pension funds and tax exempt. Between the tax payments and high discount rates used by the corporations, it is pretty clear why the TIMOs valued timberland higher than the forest industry.

Note two things from the above discussion. The “appraised value” of a particular tract of timberland, based on comparable sales, was the same for the TIMO buyer and the forest industry seller yet the real valuation for the buyer and seller were very different. As I pointed out in an earlier post; timberland valuation and fair market value are two different things!! The second point: the difference in discount rates used, combined with tax policy, has dramatically changed the face of timberland ownership and forestry practice in this country.

How do inflation and taxes affect the selection of the discount rate? We discussed that somewhat in the post on cash flows. Here are a couple of quotes, also from the Forest Landowners Guide to the Federal Income Tax, Ag. Handbook No. 718.

“it is imperative that the discount (interest) rate used for the analysis include a similar expectation factor for inflation. In summary, both elements of the analysis—cash flow and discount rate—must be kept in comparable terms (with or without inflation and before or after-tax) for reliable results.”

“Forestry investments are very sensitive to the discount rate used because of the long time period between planting and harvest. For after-tax analyses, the correct discount rate is the after-tax rate based on your alternative rate of return. If the next best alternative is a tax-free investment, such as a municipal bond, then the interest rate is used without adjustment, as shown in Table 2-3 for the 10-percent discount rate. If your next best alternative is an investment, such as a corporate bond, that yields 10 percent annually with taxes subtracted before compounding, the correct discount rate is 7.2 percent, after-tax [10 percent x (1 - 0.28 assumed tax rate)]. Alternatively, if the next best alternative is an investment such as an individual retirement account (IRA), certain saving bonds, or an alternative timber investment, where taxes are deferred until the end of the period rather than being subtracted before compounding, then the correct discount rate depends on the length of the investment period and when the costs are incurred and revenues received. Assuming an initial investment, 10 percent interest, and a 28-percent tax subtracted at the end of 34 years, the appropriate discount rate would be 8.94 percent.


Now, if you feel that you still need more info on how to select the right discount rate for a timberland purchase, let me give you a couple more references.


Finally, it may be worthwhile to speculate a little bit (actually that is what the selection of the discount rate is). Timberland investors have watched as discount rates rose early in this decade followed by decreasing discount rates which resulted in a steady increase in timberland transaction prices (and corresponding values from comparable sale based appraisals). Some TIMOs have left the market so they clearly believe discount rates got too low and pushed prices too high (potential returns too low). Other TIMOs have tried to sell large blocks but pulled them off the market. Perhaps they think discount rates are too high but prices are too low to justify selling?? Or maybe there is less money chasing timberland. This concludes the Timberland Valuation series.


Oh, I almost forgot. Nobody is going to tell you what discount rate to use. That's your call. Comments welcome. --Brian

10 comments:

  1. Interesting series. What has been puzzling me is the following questions:
    What will happen to current forest valuations if the economic climate that we are experiencing at presents represents a structural shift e.g.
    1) since mid late nineties a large share of growth in housing starts ( supporting lumber and prices and therefore stumpage value) where caused by what we today call toxic debt and this artificial demand levels will not be repeated "Reversion" to the mean or normal trend when and if it comes will involve a much lower base demand level for logs, log prices and stumpage reflecting demand levels based on affordability
    2)Newsprint and Pulp capacity is shutting down at unprecedented rates and will not be restarted due to demand shifts and more competitive substitutes. this will cause a large decline in pulpwood and chip demand. Bio energy feedstock is an alternative but can "afford" to pay a lot less
    3) Risk and discount rate calculations use gilts as benchmark,how does "printing" money and quanititative easing influence future WACC or hurdle rates
    4) The relative risk/return of Forestry e.g. Equities are 30 to 50% BELOW Fair value
    Anybody got any views

    ReplyDelete
  2. Interesting series. What has been puzzling me is the following questions:
    What will happen to current forest valuations if the economic climate that we are experiencing at presents represents a structural shift e.g.
    1) since mid late nineties a large share of growth in housing starts ( supporting lumber and prices and therefore stumpage value) where caused by what we today call toxic debt and this artificial demand levels will not be repeated "Reversion" to the mean or normal trend when and if it comes will involve a much lower base demand level reflecting demand levels based on affordability and therefore depress demand for logs, log prices and stumpage.
    2)Newsprint and Pulp capacity is shutting down at unprecedented rates and will not be restarted due to demand shifts and more competitive substitutes. this will cause a large decline in pulpwood and chip demand. Bio energy feedstock is an alternative but can "afford" to pay a lot less
    3) Risk and discount rate calculations use gilts as benchmark,how does "printing" money and quanititative easing influence future WACC or hurdle rates
    4) The relative risk/return of Forestry e.g. Equities are 30 to 50% BELOW Fair value
    5) How long can TIMO and Reits stock up BEFORE MARKET FUNDEMANTALS CATCH UP?
    Anybody got any views

    ReplyDelete
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