Forest Finance: When is the “Current Stand Approach” Useful for Valuing Timberlands?

30 01 2013

When talking about timberland investing while having a beer or standing over the hood of a truck, not when signing checks or allocating capital…..

A reasonable estimate of a forest’s current economic value equals the standing merchantable volume multiplied by the current stumpage prices in the local market. Investors sometimes use this “back-of-the-envelope” technique to estimate the liquidation value of a timberland investment or forest-owning firm. However, this basic approach suffers from observable, value-destroying limitations.  Why? It ignores the potential for generating greater wealth by holding the forest to economic maturity, investing in forest management, identifying other revenues, or accounting for taxes or opportunity costs associated with the land and capital.

This snapshot value faces other weaknesses.  First, current realizable values for the standing timber will be low at any given point in time.  Also, for large timberland ownerships or plantations, the local market can rarely absorb a total liquidation (clear cut) of inventory without depressing local prices.  From a valuation standpoint, the former incents conservatism and the latter incents unreasonable optimism.  Generally, appraisers valuing forests completely avoid current stand valuations (in writing)…..

Click here to register for “Applied Forest Finance” on February 7th in Atlanta.  The course details skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments.

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Forest Finance: Common Errors and Suggested Solutions

23 01 2013

News flash: we all make errors when analyzing forestry investments.  Which are the most common and how can we avoid them?

At the end of the day, most analytic errors in forestry relate to the data used – the inputs – or the math in a spreadsheet.  Errors associated with inputs affect the cash flows in the analysis and how it impacts value when discounted back to the present.  When reviewing models for clients, we commonly find errors associated with the assumed costs, the estimated revenues, the timing of cash flows and the expectations associated with inflation and asset appreciation.  Specifically, in our work and the work of others, we focus on and observe three major categories of errors in Excel models and spreadsheets.

First, we find that analytic errors in Excel are common.  Of all of the spreadsheet models we review, approximately one-third have an error in a formula (that we find). Most often, these are associated with “relative” and “absolute” referencing, where a formula is pulling in data from the wrong cell or worksheet.  Professor Ray Panko at the University of Hawaii, who actually conducts spreadsheet research (http://panko.shidler.hawaii.edu/ssr/), noted in a 2006 interview with the Wall Street Journal that “you’re going to have undetected errors in about 1% of all spreadsheet formulas.”

Second, we observe application errors, which basically reference issues with the thinking behind the spreadsheet, the formula chosen, the use of a formula, or a comparison made.  For example, analysts commonly make mistakes with inflation by mixing real and nominal discount rates and cash flows.  Also, spreadsheet models of forestry investments may inappropriately compare before and after-tax results and investments of differing duration (time periods). Finally, using the incorrect metric can be problematic, such as misapplying cash-on-cash return, pay back analysis and internal rate of return (IRR).  We typically find errors of this type when analysts are comparing timberland and forestry investments with alternative asset classes, such as stocks, bonds, agricultural commodities and commercial real estate.  Historically, the day-to-day metrics for forestry differed in application, so a bit of time spent checking assumptions and thinking through the communication of results can be helpful.

Third, errors of omission are especially problematic (and embarrassing).  We work hard to avoid the situation of being asked “did you check _____?” and, if relevant, having to answer “No, we didn’t think of that.”  Ugh.  Unfortunately, we find that third-party spreadsheets often omit key facts or considerations, including relevant costs and potential revenues.  Just as important can be confirming that the assumed costs and revenues are current and reflect the best available, accessible information.  In short, know what’s knowable.

We observe a few key practices in our work with clients to minimize the chance and occurrence of errors.  First, we label tabs and worksheets, and date all files. That way, if we revisit a model several weeks or months later, we can retrace our steps and know what we’re working with.  Also, if we correct an error or make another improvement, we know which version is the most current.  Second, we try to set aside time to check each other’s work before sending results “out the door.”  Admittedly, this is also the most challenging.  We find that imposing and embracing milestones – midpoints for deliverables or reviewing work – throughout a project institutionalize a level of quality control.  Finally, at the end of the day, we ask ourselves the question “where could we have blown this?” Some level of paranoia and self-awareness is required for quality analysis of forestry, or any other, investments.

Click here to register for “Applied Forest Finance” on February 7th in Atlanta.  The course details skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments.





Forest Finance: What Does a Negative or Zero NPV Say About My Potential Timberland Investment?

16 01 2013

Attention shoppers!  An NPV of zero does not necessarily indicate “bad investment.” 

Previously, we discussed applications and limitations of using cash-on-cash (COCR) return as a metric for analyzing forestry and timber investments, as well as questions related to internal rate of return (IRR) and return on investment (ROI).  This generated a question from readers related to net present value (NPV): “Should a negative NPV automatically kill a potential forestry investment?”

Short answer: NO.  Let’s discuss.

NPV is the present value of future revenues minus the present value of future costs.  It is a measure of wealth creation relative to the discount rate.  So a negative or zero NPV does not indicate “no value.”  Rather, a zero NPV means that the investment earns a rate of return equal to the discount rate.  If you discount the cash flows using a 6% real rate and produce a $0 NPV, then the analysis indicates your investment would earn a 6% real rate of return.

Additionally, a negative NPV means that the present value of the costs exceeds the present value of the revenues at the assumed discount rate.  Any investment will produce a negative NPV if the applied discount rate is high enough.  So it makes sense to double check the estimated costs to look for opportunities to economize, to review the sources of revenue to seek potential enhancements, and to revisit the assumed discount rate.

Click here to register for “Applied Forest Finance” on February 7th in Atlanta.  The course details skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments.





Forest Finance Q&A: Cash-on-Cash Returns versus IRR and ROI for Timberland Investing

9 01 2013

While cash-on-cash (COCR) return – a percentage often used by investors to evaluate income-producing real estate – has limitations when applied to timberland investment performance, it consistently generates interest from institutional investors.  Below are questions analysts asked us about COCR:

Q:           When estimating internal rate of return (IRR) for a timberland investment since inception based on cash returns, why are timberland portfolios often zero or negative?  How can we recommend such investments?

A:            Timberland investments often have periods of low or negative cash flows, especially when timber prices are low and forest managers delay harvest activities.  In fact, noting that a given tract of timberland has negative cash flows for a given year does not tell us much at all about the quality of the investment.  For example, replanted timberlands generate negative cash flows today and may represent robust and attractive investments.

Calculating negative net IRRs that fail to include an assessment of net asset value (NAV) is like summing cash flows to date and subtracting the purchase price.  This would represent “payback analysis” misapplied.

Q:           What is the difference between return on investment (ROI) and COCR?

A:            Consider the following example:  you acquire a timberland tract for $500,000 and sell it later for $550,000. Your ROI is 10%. The 10% return ($50,000 increase on $500,000 purchase price) reflects the increase in your “total investment (Loan + Down Payment).”  If you put down 50% ($250,000), not accounting for closing costs and commissions, your cash on cash return is 20%. The return you made on invested CASH is 20% ($50,000 increase on $250,000 cash invested).  If you paid all cash for the tract, then COCR and ROI are equal.

Click here to register for “Applied Forest Finance” on February 7th in Atlanta.  The course details necessary skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments. 





Forest Finance: Cash-on-Cash Returns, Part II

6 01 2013

As noted in Part I of this series, cash-on-cash return (COCR) provides one way for real estate investors to quickly compare the profitability of different income-producing properties or investments. However, it has limits for measuring returns or wealth creation over time.  This makes cash-on-cash returns a problematic performance metric for timberland investments.

Specifically, COCR does not account for the time value of money. Cash-on-cash return must be restricted to simply measuring a residential income property’s first year cash flow and not its future year’s cash flows.  Why?  The first year’s COCR estimate will be the most accurate; each successive year becomes increasingly speculative.

Also, COCR does not account for appreciation.  Lower COCR today may lead to a greater opportunity for appreciation than acquiring a property with steady COCR and little or no appreciation.  For timberlands in particular, a meaningful analysis should account for the facts that rates of timber growth differ by age, investment objectives differ by timber portfolio, and the pace of increased values vary as forests grow and move through higher product classes in changing markets over time.

For example, buying and owning a juvenile 8-year old forest for ten years may generate minimal cash flows while appreciating in value through biological and product growth.  Alternately, buying and owning a mature 30-year old plantation may generate tremendous cash flows in the first year while appreciating minimally.  While the juvenile forest may have a low COCR, it may in fact prove a superior value creating investment when evaluated using discounted cash flow (DCF) measures such as net present value (NPV) and internal rate of return (IRR).

The next post will compare COCR to internal rate of return (IRR) and return on investment (ROI) for evaluating timber investments. Click here to register for “Applied Forest Finance” on February 7th in Atlanta.  The course details necessary skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments. 





Forest Finance: Cash-on-Cash Returns, Part I

1 01 2013

Timberland investors naturally care about the cash flows and distributions from timberland investments over time.  These cash flows vary with the products grown, markets served and age distribution of the forest owned.  Also, timberland portfolios can be constructed to meet a range of cash flow objectives.  That said, the use of cash-on-cash returns as a performance metric for timberland investments has narrow applications, if any.

What is cash-on-cash (COCR) return?  It is a measure – a percentage – often used by investors for income-producing real estate.  It is calculated by dividing before-tax cash flow by the amount of cash invested (down payment amount).  If for example before-tax cash flow for an investment property is $15,000 and our invested cash is $100,000, then COCR is 15% ($15K/$100K).

Most reported returns from timberland investments reflect unrealized gains. Timberland indices and appraisals have limitations, complicating efforts to check the status of active timber investments.  This spotlights ways to use hard measures – like cash – to assess performance.   As such, investors new to the timberland asset class often ask about the use of cash-on-cash returns for timberlands, and seek to apply it as a point of comparison.  A meaningful analysis benchmarks cash flows relative to expectations – not just the current year – and relative to comparable investment alternatives.

Part II details limitations of COCR for evaluating timber investments.  In addition, this topic will covered more fully during the February 7th “Applied Forest Finance” course in Atlanta. Click here to register.  The course details necessary skills and common errors associated with the financial and risk analysis of timberland and other forestry-related investments.