Valuing Timberland IV

This is the forth 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. Today, I’ll focus on how all of the previously discussed factors are tied into some form of discounted cash flow (DCF) model.

Foresters and most financial types are well versed in DCF, what it is and why it is so important. Its use can be traced back to Martin Faustmann, a German forester, in an 1849 publication on valuing immature stands. By the 1930’s, the financial community had recognized its importance and began incorporating it into investment analysis.

Here is the definition of DCF according to Investopedia: A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Forget that comment about the “weighted average cost of capital” and we will talk about that in the next post. This post will touch on the following issues.

• Cash flows: Revenue from timber sales, leases, HBU sales, etc.; silvicultural expenses, taxes, management fees and other costs.
• Inflation and taxes
• Spreadsheet models, computer programs, harvest scheduling software
• Location: Important? Can it be quantified? Final sale price: When you sell the land, how much will you get? Existing cons easements
• Discount rate: very, very important and will be discussed in next post

Cash Flows: The costs and revenues, and when they occur, constitute the cash flows used in a DCF analysis. The entire process can be visualized utilizing a timeline such as the one below from a forestry investment example illustrated in the Forest Landowners Guide to the Federal Income Tax, Ag. Handbook No. 718.



The cash flows illustrated in this timeline are shown below.


This is a very simple example but it illustrates the process very well. Note that some of the flows occur in a particular year and some recur every year. Although the costs and revenues occur at different times, they are all discounted back to the present to determine the value today. There is a very thorough explanation of the process accessible by the link above. Note that in this example, the land purchase price is included at the start of the analysis and then the land is sold in the final year. An alternate approach is to create the cash flows in perpetuity (don’t include the land cost) and discount them back to the present. The result is the value of the land BUT only if you hold it forever any your cash flow calculations never change! If you plan to sell off some HBU land in the early years or if you see real increases in land value at the end of the investment, you MUST include land cost. If a conservation easement has been sold, the revenue should show up in the appropriate place AND the final sale price must be reduced by the appropriate amount.

What about inflation and what about taxes? Should they be incorporated into the cash flows? The answer is fairly clear, with respect to taxes, if the owner, such as a pension fund, does not pay taxes! For every investor though, there is a clear answer. Include them IF they are included in the discount rate. Here are a couple of quotes, also from the Forest Landowners Guide to the Federal Income Tax.

“Most forestry costs change at the rate of inflation in the economy; however, stumpage prices may increase (or decrease) at rates exceeding (or less than) inflation when supply/demand relationships change. These differential price trends can cause miscalculations in an investment analysis. Real (exceeding inflation) price appreciation—or price depreciation as the case may be—for some products, such as Southern pine and Douglas-fir sawtimber stumpage, has received much attention. But other product prices, such as those for pine and hardwood pulpwood, and equipment costs, also have been affected. Predicting the future always is uncertain and hazardous, so the best information available for projecting real changes in cash flows should be used.”

And the second quote: “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.”

The take-away here is to include inflation in the cash flow if you think it is appropriate and to include taxes in the cash flow if you think that is appropriate, but you must incorporate those elements in the discount rate if they are included in the cash flow. My solution, when building a model, is always to create the discount rate as a variable. Then model the discount rate so the analysis can instantly be modified by setting the inflation and tax rate variables (either or all) to zero. If you don’t do this, I promise that someone will ask you “What if…”

Let me also add that there are some complexities associated with timber depletion that will create some pitfalls for the model builder not experienced with forestry taxation (depletion and multiple tax rates). The taxation issues are further complicated by the “inflation tax”. Maybe someday I will do a post on that too but not today. For now, let’s look at the types of software available to do DCF analysis of timberland investments.

Spreadsheets, forestry investment software programs or Harvest Scheduling software?

Spreadsheets: This is the “roll your own” option. It has some advantages but some very powerful disadvantages as well. The biggest advantage is that you can do it your way, you already have the software (and you can distribute the model to everyone in your organization) and you understand all of the drivers used. It is a good solution for simple situations like the one above. The disadvantage is that you really have to understand forest management, DCF, forest taxation, depletion accounting, G & Y models, spreadsheet development and probably a few things that I have left out. I have constructed complex models used for evaluating large transactions so it can be done. But the results fall short in many ways.

Forestry Investment Software Applications: These applications, frequently web based, are a good alternative to the use of spreadsheets if the target tract is not to large or complex. There are usually multiple applications in each suite which allow calculations designed to feed the DCF application. Growth and yield models may be built-in or a part of a supporting application. Applications that allow projections of both real and inflated timber prices (and land prices) are available to help feed the DCF analysis (remember to use a discount rate that is consistent with the inflation/real price). They have “help files” that explain the terminology and provide guidance in usage. They are generally easy to use and they are free.

Two examples can be found on web sites at Mississippi State and the Texas Forest Service. See FORest VALuation or FORVAL Online and the Timberland Decision Support System. You can actually use both of these sites to create your cash flows and then enter them into the Texas site.

The MSU site also has G&Y models for loblolly, slash and longleaf as well as some calculators to let you look at real increases in timber values (can also be used for real increases in land values as well). The Texas site also has several supporting “calculators” including The Timberland Management Simulator which integrates a loblolly G&Y model with the financial analysis.

There is other software available that you can find with a Google search. Some of the software is web-based and some requires downloads. I prefer the web-based stuff because it is more likely to work without problems. There are some very good G&Y models that have been “left-behind” because they no longer behave well (or at all) on the current operating systems. Another advantage of the web software, particularly over spreadsheets, is that they have well thought out explanations of the terminology and give you some good advice on how to conduct your analysis.

Harvest Scheduling or Forest Planning Software: What is Harvest Scheduling? First of all, the term is a misnomer. It is a carryover from earlier linear programming models that focused on the best time to harvest stands. Today’s applications, best referred to as Forest Planning applications, are far advance from just projecting harvests. All of the activities from planting through harvest are included while measuring the impact on attributes such as habitat, wood flows and cash flows are reported. The earlier applications have morphed into spatial applications importing GIS data and producing maps that show the “where” of all activities in the plan. The spatial applications also allow the use of spatial constraints, such as “green-up” requirements. The following paragraphs are from NCASI’s HABPLAN, spatial Forest Harvest and Habitat Scheduling software, users manual. I selected them to give you a better understanding of harvest scheduling and its complexities.

************************************************************
“Harvest scheduling entails the application of mathematical programming techniques to determine the allowable cut and/or the cutting budget, for a given area of forest, over multiple rotations or cutting cycles. With sustainability being a buzz word in the forestry industry, a number of harvest scheduling methods have been (and continue to be) developed that help us to manage our forests on a sustainable basis. The basic management unit is the forest stand (or a polygon comprising multiple stands). It is desirable that each management unit be managed in the most environmentally, economically and socially beneficial way. For each management unit, however, there are numerous management regime possibilities. The following are a few variables, which contribute to the wide range of potential management regimes.

• species
• site quality
• age of current stand
• length of rotation
• number of thinnings (& ages at which they occur), and intensity thereof
• regeneration or replanting
• greenup window

The potentially complex procedure of developing and solving a harvest scheduling model can be summarized in the following steps:

• Decide on decision-making variables. In Habplan, where integer programming is used, each decision-making variable represents one whole management unit (forest stand or polygon), i.e. each management unit can only be assigned one management regime. However, in linear programming, it is assumed that each management unit can conceptually split up, and managed under a number of different regimes, thus creating a number of different decision making variables for each management unit.
• Develop the objective function, according to the objectives of the given harvest scheduling problem.
• Incorporate various constraints e.g. land constraints, volume flow constraints, financial constraints and ending inventory constraints.
• Use a mathematical programming technique to solve the problem for the optimal/best solution.
• The solution to such a problem should offer information on which management units (or how much of each management unit) to devote to each of the proposed management regimes.

There is no one computer program in the world that can account for all variables in nature. Therefore, it is important to keep in mind that harvest scheduling is merely man's best effort at simplifying a very complex and dynamic natural phenomenon into a mathematical formula, and does by no means offer the perfect solution in the quest for the optimal management regime. However, it is safe to say that various harvest scheduling methods are capable of providing fairly reliable guidelines, by which land can be managed.”

**********************************************************
The above paragraphs illustrate the complexities and capabilities of harvest scheduling. In addition to Habplan, there are several other applications available. The hands-down favorite of forest planners is Remsoft’s Forest Planning System (Woodstock and Stanley) regarded as the best available by most users (at least managers of 500 million acres on five continents)!

It takes very well trained people to prepare a harvest schedule or plan. From personal experience, I can say that Remsoft also offers excellent training programs and support for its products. Some companies and TIMOs have trained people and do their own plans. Others use forest consultants that have experienced harvest scheduling people on their staff. One company, FORSight Resources, actually specializes in harvest scheduling and has several world-class authorities on the subject.

The take-home for the harvest scheduling discussion is that it is the best DCF methodology for a major acquisition because:

• It seeks optimization of management scenarios.
• The better versions allow spatial constraints and provide spatial output.
• It allows the addressing of very complex issues that other solutions are not capable of doing.
• Optimal solutions form the basis of the future management plan.
• There is some very good software available with tools built that reduce the complexity of the mathematical programming.
• But… it is complex, time consuming, and must be implemented by specialists

Summarizing:

• because of the timeline associated with the cash flows of all timberland investments, DCF is a requirement of all valuations (except the flip!)
• for large timberland transactions, use harvest scheduling software
• for small tracts (up to a couple of thousand acres) and infrequent purchases, use freely available forestry investment software
• for frequent purchases/valuation of smaller transactions, spreadsheets may be the better choice.

This concludes the DCF discussion. The next, and final, post in this series will focus on the choice of the discount rate and how critical that decision is to the outcome of the valuation. Comments welcomed. --Brian

Valuing Timberland III

This is the third 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. Today’s post will focus on estimates of timber volumes and values, how we get them, and how we forecast them for future year’s cash flows. We will also take a quick look at the confidence you should place in them.

First, let’s look at timber volumes. What does the cruise say? What does the inventory say? What is the difference? How was the acreage calculated? Are volume estimates tied to a GIS? What are the sources of errors? Can volumes be reasonably audited? If the volume estimate isn’t “right”, the value certainly won’t be!

What is a “cruise”? A survey of forestland to locate timber and estimate its quantity by species, products, size, quality, or other characteristics; the estimate in such a survey. Several different sampling techniques can be used in a cruise. (source: Forestry Terms for Mississippi Landowners, Mississippi State University Extension).

What is an “inventory”? See Cruise (same source). H’mmm. I don’t want to aggravate my Mississippi State colleagues or to argue semantics but there is a huge difference between a cruise and an inventory or, more appropriately, a timber cruise and a forest inventory. To keep it simple, the cruise (as correctly defined above) collects data to estimate the timber volume, quantity, etc. that is there right now. The forest inventory collects much more information which can be used to project volumes and harvests (and other stuff too) into the future. A cruise, as defined above, wouldn’t collect any information on an eight year old loblolly pine plantation. There is little or no volume (perhaps a few trees that meet the limits of merchantability) but there certainly is value. A forest inventory would want to know the species, age, trees/acre, site index and acreage at a minimum. That is the information that is necessary to drive the growth and yield models necessary to estimate future wood flows from the tract. The wood flows become the basis for the cash flows in the appraisal. Perhaps this is just semantics but it is very important to understand the difference and to know what you are looking at.

So the “acquisition cruise” necessary to purchase land is more appropriately referred to as a forest inventory than a cruise. A “timber cruise” is more likely used to determine the immediate value of the timber for a timber sale. Data to drive growth models or cash flow models is not necessary. This distinction is more than academic. The inventory data can be “grown” to provide volume information for appraisals, stand level info for thinning or harvest, projected harvest and regeneration sites for planning site preparation and planting, all at multiple forward points in time. A typical cruise is not designed to do this. Merchantability specs are frequently different between cruises and inventories resulting in differences in volumes reported. Merchantability specs for inventories must be consistent from tract to tract, year to year, cruiser to cruiser and they must be consistent with what the growth models require. Merchantability specs for a timber sale cruise will normally be modified to conform to current demand, market pricing and perhaps even the logger that will be doing the harvesting.

The lesson here is that the user of cruise or inventory information had better understand what he or she is looking at. The cruise/inventory designer needs a clear understanding of the objective of the cruise. Otherwise, expect disappointment.

The sampling intensity of most inventories will not provide adequate data for timber sales. Inventories must collect some information on every stand or stratum (a collection of stands with similar characteristics). The objective of an inventory or cruise is to gather the information that is necessary at an acceptable level of accuracy at the least possible cost. Contrasting the two extremes, consider the case of a 100,000 acre land acquisition compared to a 50 acre mature hardwood timber sale. The objective of the land acquisition inventory is to be accurate enough to generate a reasonably accurate cash flow analysis for the perceived life of the investment (and hence, its present value). Another objective may be to assist in management if the tract is purchased. The resulting inventory would be one with a low sampling intensity but one collecting much information at each sample plot. The inventory is “not accurate” at the stand level. Cost is a serious consideration. If the tract is not purchased, the entire cost of the inventory is wasted. The 50 acre timber sale, on the other hand, has a much higher sampling intensity (perhaps a 100% tally), does not require collecting growth modeling information and requires careful inspection of the quality of each tree relative to current market conditions. The cruise cost/acre is much higher but the payback is immediate and ensured.

Statistics 101: Reiterating an earlier point when addressing timber volume reports; you had better understand what you are looking at. Most well done cruise reports will provide some detail with respect to the statistical accuracy provided by the data. You will see something like “2,216 MBF ± 10% of hardwood sawtimber”. This means, that from a statistical standpoint, the actual volume will be within 10% of the volume estimate 95% of the time, or maybe 90% of the time, or maybe 66% of the time. Maybe you better ask which probability level applies! You will probably also see a volume by species report and perhaps that will also provide statistical error reporting too. If it doesn’t, you should understand that because the sampling intensity for any given species is well below that of all of the species combined, the accuracy of the estimate drops pretty dramatically in a mixed species stand or forest. Now, digging into the cruise report a little deeper you will see that volumes may be reported by species and diameter class. How accurate do you think that will be? If the statistics are reported, that is great. If not, beware the value that you place in the numbers. This information can be useful but you have to assign it the appropriate credibility.

You should also understand that there are other sources of error in a cruise in addition to the statistical sampling error. Examples are the use of incorrect volume tables, measurement errors, poor sample design, calculation errors and, yes, a poor cruiser.

The statistical accuracy of large inventories that have been conducted over several different years and have been brought current using growth models is a different story. I’m not going to get into how to do this because I have no earthly idea how to do it! It can be done by a fairly limited group of forest statisticians, mensurationists and biometricians but it is clearly a difficult task. As a rule of thumb, it is safe to say that the accuracy is somewhat less than what would be calculated using the “ungrown” plots and declines as the number of “grown” years increases.

That’s enough said about cruise reports, inventories and the timber volumes that they report. Now let’s talk about volumes that what will be there tomorrow and the fundamentals of creating a future wood flow.

Future harvest volumes and timing must be done on a stand by stand basis utilizing stand volumes that have been “grown” using yield tables and growth and yield models. The starting base is the stand or strata level inventory and each stand or stratum is grown into the future. Some rule or methodology is then used to select the harvest date to determine the harvest volume for each future year. The result is a wood flow model that, when combined with values, becomes a key component of the cash flow model. More detail about this will be provided in the next post.

This is probably the appropriate place to discuss the integration of a GIS (Geographic Information System) with the timber inventory system when creating the information system used for timberland management. GIS based inventory systems are very common among managers of large tracts of timberland today and sellers normally provide output from these systems to potential buyers. Inventory or cruise volumes may say what is out there but the GIS says exactly WHERE it is on the surface of the earth. A quick check of the validity of the data provided by the seller can be made by auditing selected stands to compare inventory acreage, stocking, volumes, forest types, SI, etc. to the audited values. It doesn’t take much of this type of checking to determine how serious the forest managers have been about the quality and timeliness of their inventory efforts and hence the credence that can be placed in the data provided. The GIS data can be “read” into the GIS based harvest scheduling/ cash flow models and will eventually provide the basis for future management (activity schedules, maps and annual cash flow projections). These are the tools that become the foundation for communications and expectations between the new landowner and the timberland managers. The schedules tell the owner what to expect financially and form the basis of the management plan for the manager. A final point about the GIS based inventory system is that it provides the basis for a field audit in conjunction with the traditional financial audit. In the timberland sector, a financial audit without a corresponding field audit is a serious mistake; in fact, it's not really an audit.

Now let’s discuss timber values. They are down! A lot! If you are selling timber today, that is very important but how important is it with respect to timberland valuation? Should current market conditions be used for valuation?

The comments below are by Rick Holley (from Plum Creek 2008 Q3 Earnings Conference call) answering an analyst’s question about why he thinks timberland values are holding up while other asset classes are declining in value. The quote is a little messed up but his point is clear.

“I think largely because the investor in timberlands, and there’s still a fair amount of capital on the sidelines trying to invest in timberlands, is longer term. They’re looking through this cycle. If anything they’re starting to look at this cycle and lower prices as being more upside when you look out a year or two years or whatever these markets improve. I know there was a recent [Reese] article talking about some transactions that may or may not get done. We’re in the marketplace and we talk to a lot of buyers. We know who the sellers are, and we think all those transactions will in fact get done at very, very good prices, so I think the market is holding up and there’s still a lot of capital chasing very little opportunity…”

The key words above are “looking through…” with respect to timberland prices. To me, that implies that they are also “looking through” with respect to the timber values used in the timberland valuation. I think that if stumpage prices were at all-time highs, buyers would “look through” and see lower prices in the future as well. As Andy Malmquist, my good friend, former employee, and current TIMO guy, used to remind me about so many things… “It’s regressing toward the mean”! Andy actually talks like that.

There are at least three factors to consider for determining future timber values to apply to future volumes – current values, real price increases and inflation. We will discuss how to address inflation in the next post so for now, we will confine the discussion to the first two items.

I am defining “current price” as a “look through” price that is on the trend line for the species,local area and region (huge differences between NE and NW, cherry and red maple). In other words, I am looking for the price that has “regressed to the mean”. This data can be obtained from several different pricing services such as Forest2Market, RISI and Timber-Mart South. In addition, most state forestry commissions (South Carolina Forestry Commission pricing report) or forestry university extension services also provide some level of pricing reports. Local consulting foresters usually know what is available and can also provide first hand local knowledge. Pricing from these sources will provide the baseline for projecting the value of future harvests in the cash flow model.

A real increase in future stumpage prices can and should be incorporated into the model if you think it is justified. U. S. Forest Service reports suggest that sawtimber stumpage prices have increased at a real rate of 2% a year over a very long period of time. An analysis of southern pine stumpage prices by forest economist Jack Lutz reached the following conclusion:

“Our analysis indicates that southern pine sawtimber stumpage prices are mean-reverting, with a 50-year mean of $38.29/ton (based on LDAF data). Those prices have held to that mean through 50 years of timber supply and demand shocks and significant changes in timber harvesting and processing technology. That means we should not expect a significant increase in sawtimber stumpage prices in the near future. This supports the current practice of many timberland investors who are using 0% real appreciation rates in their timberland investment models.”

The future is anybodies guess but the real value increase used should be based upon your view of the future. That’s why there is always a high bidder and a low bidder!

This concludes the discussion on timber volumes and values. The next post in the series will attempt to tie it all together by addressing the methodologies associated with the discounted cash flow models. Comments are welcomed. --Brian

Valuing Timberland II

This is the second post 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. Today’s post will focus primarily on productivity and how that fits into today’s appraisal systems which use discounted cash flow techniques to determine the value of timberland.

Productivity is key to determining the value of timberland. Some of the productivity is inherent to the land itself and some is a function of the intensity and effectiveness of the silviculture practiced on the tract.

First, let’s look at the inherent productivity of the land. Foresters measure that with a metric referred to as Site Index. Site Index (SI) refers to how tall a given species of tree can grow on that particular site in a specific number of years. Examples might be Loblolly Pine, base age 25 years, SI 60. Or Red Oak, base age 50, SI 60. Or Cottonwood, base age 10, SI 60. All of these are realistic examples and I have worked in stands with these exact site indices. The sites are not similar though. Note that all of the examples are “Site 60” land meaning all of those species will grow to sixty feet in height but it takes the cottonwood only 10 years, the loblolly pine takes 25 years and the oak takes 50. The land supporting these three site indices would also look very different. So SI defines the productivity for a particular species on that site. As a matter of interest, the SI 60 examples given for Loblolly (25 years) and Red Oak (50 years) are reasonable and quite common. The SI 60 (10 years) for cottonwood is actually a very poor site. Cottonwood on a good site can attain 100 or more feet in 10 years! Neither loblolly pine nor red oak could even survive on these sites due to the prolonged flooding during the growing season. The site determines the best species to plant or to favor with natural regeneration.

Let’s look at site productivity in more detail. In the late 60’s and early 70’s I was buying timberland in North Mississippi and West Tennessee. My counterparts (in other regions) and I were tasked with developing a new appraisal system based upon minimizing the cost to the pulp mill rather than the minimizing the bare land value. A key component to valuation is the objective of the owner and I was working for a pulp and paper company that owned land for the purpose of supplying its mills. And remember this, timberland valuation and fair market value are two different things!! That’s why there is always a high bidder! Under this type of a valuation model (delivered cost), it should be very clear that the more productive the land (i.e. the higher the SI), the more wood that would be grown and the lower the delivered cost per ton would be. In addition, there was already a significant acreage of 10 to 15 year old established loblolly pine plantations on private land in the area that had been established by the U.S. Forest Service Yazoo – Little Tallahatchie flood prevention project. Cattle prices were high and the plantations were being cut, cleared and put into pasture. In general, fair market value for timberland in the area was essentially the pulpwood value of these plantations (very low because of their age) plus bare land value.

Our appraisal system team created the details for a model which estimated a future cost per ton delivered to the mill. Obviously, the tracts with the lowest cost per ton were the tracts most desirable to the company. Bare land value was still there and served as a checkpoint against “fair market value” (FMV). The new method was very different from the old in that it represented the beginnings of a cash flow model and timberland productivity became a very important driver. The “Growing Cost” of the model was actually a future value of the cash flows and was very dependent on the productivity of the tract. The impact of the increase in growth alone between SI 60 and SI 70 for loblolly pine is about 30%. Jack it up to SI 80 and the gain is almost 60%! It’s pretty easy to see the significance of productivity gains on valuations dependent on the amount of timber that will be grown in any given amount of time. The “take home” point of the last couple of paragraphs is that the greater the inherent productivity of the land, the more positive the impact will be on an appraisal system employing a discounted cash flow model. And the greater the price that informed buyers will pay for it. We’ll discuss more about the pine plantations mentioned above a bit later. But first we must talk a little more about productivity that we can impact and something called yield tables.

The second factor addressing forest productivity is silviculture. Silviculture can be briefly defined as - the art, science, and practice of controlling the establishment, composition, growth, and quality of forest stands. Silviculture is to the forester what agriculture is to the farmer. It is a broad term encompassing preparation of the site, selection of the species to be planted, selecting the seed with the best genetic capabilities, fertilization, planting, density control, weed control and harvesting. Silvicultural systems employing artificial regeneration, planting or direct seeding, are more in line with agriculture but natural stands employ similar practices to obtain the desired species composition and density control too. The decision to employ a silvicultural system with a focus on natural regeneration versus plantation management has a huge impact on cash flow and profitability (and therefore valuation). Natural forest management regimes have less cash out and less cash in. Which system, natural or plantation, is best depends on the objectives and circumstances of the owner. So…, site quality refers to the natural productivity of the site whereas silvicultural activities are things that we can do to increase the productivity of the forest. At a cost.

To a degree, the current productivity may be what nature provided us (really it is more what past “managers” left us with rather than what nature provided us with). The existing forest type (a classification of forestland based on the species forming a plurality of live tree stocking) may be a 20 year old oak-pine stand or a 10 year-old loblolly pine plantation. The two have very different productivity potentials going forward. There could easily be a five-fold increase in productivity between the two forest types on similar sites. In some cases, the forest manager has the option of changing forest types through the process of harvesting, site preparation and planting. Greater productivity, greater cost.

Inherent in the example above is greater control of stand density or stocking through planting. Control of stand density is critical to maximizing productivity. So what is stand density? I don’t want to get into a forest mensuration short course here so just think of stocking as the combination of the number and size of trees that will provide optimum growth for a particular site. Stocking charts frequently classify stands as “understocked”, “well stocked” or “overstocked”. A “yield table”, mentioned earlier, combines the stocking level with Site Index to forecast what the yield of forest products will be at some future point. This tool is critical to determining the future productivity of the forest and to the timing necessary for the discounted cash flow analysis. For the purpose of explanation and understanding, I have created the super simple yield table below.



A “real” yield table can go on for pages with many different site indices, ages, stocking levels and products but this one will illustrate the points that I am trying to make. Note how the yield (in this case cords/acre at age 25 but could be MBF at age 20) changes with both stocking (trees/acre at Age 1) and site index. Using these variables we can forecast both volumes and cash flow at the time of harvest. And what if we plant genetically improved stock that increases growth that is the equivalent of a 10 point jump in SI? Or phosphorous fertilization on a P deficient soil? Silvicultural activities have a major impact on the yield but “in the old days” we were pretty well restricted to the yield tables and they served us quite well. Today, however, they have generally been replaced with much more sophisticated growth models which are not only capable of predicting growth based on stocking and SI, but on all of the silvicultural practices that impact those metrics.

I feel that I have rambled a little too much in some places and not been clear enough in others so let me summarize the key points.

Forest productivity, both inherent (SI) and developed (silvicultural activities) is probably the most important driver in the cash flow analysis of timberland. Tools are available to measure and project the volumes into the future. Yield tables for volume projection have been replaced by growth models. You can download and learn to use a loblolly growth and yield model from Mississippi State here (CUTOVER LOBLOLLY GYM). It allows you to manipulate the SI and stand density and to see the future output. It also allows you to assign values by product which we will discuss next time.

Timberland valuation and fair market value are two different things! Remember above when I talked about buying 10 to 15 year old established pine plantations? The FMV (based on comparable sales) was about $125/acre in 1970. We began paying $150 - $175/ acre and easily acquired a significant acreage of these plantations. The value that we were assigning was the future value discounted back to the current age as opposed to FMV. Ten years later we were harvesting $1000/acre worth of chip-n-saw from these sites. We recognized that the FMV was well under the actual value of the plantations and were able to capitalize on that. Some of the early TIMOs were able to do the exact same thing with pre-merchantable plantations on a much larger scale. Some of the early TIMOs saw the value in HBU lands and disaggregation and recognized that the sum of the parts was worth more than the whole. These values are now well recognized in a competitive market and the returns, as expected, are dropping. The lesson is that there is a good return to be had if you can recognize a difference between the real value and the FMV.

Location can be very important or fairly minor. In the case of a forest products company valuing timberland, distance to the mill can be critical (as is the case with an institutional investor committed to a fiber supply agreement requiring delivery!). Some states have real estate tax structures which have a significant impact on cash flow evaluations. But frequently, location has minimum bearing on valuations for an investor.

So much for the value of productivity. The next valuation post will focus on estimates of timber volumes and values, how we get them, and how we forecast them for future year’s cash flows. We will also take a quick look at the confidence you should place in them. --Brian