|(a) The Comptroller of Public Accounts adopts a Manual for Discounting Oil and Gas Income, with text as follows. (b) Basis of the Manual for Discounting Oil and Gas Income. (1) Property Tax Code, §23.175, enacted by the 73rd Legislature, 1993, requires the comptroller's office to develop and distribute to each appraisal district an appraisal manual that specifies the methods and procedures to calculate the present value of oil and gas properties using discounted future income. The 82nd Legislature, 2011, amended Property Tax Code, §23.175 to require the comptroller's office to specify the formula to be used in computing the limit on the price for an interest used in the second through the sixth year of an appraisal, beginning with the 2012 tax year. The formula is specified in subsection (p) of this section (Appendix 5). (2) Section 23.175 also directs each appraisal district to use the specified methods and procedures. (c) Introduction. (1) This manual explains the concept of discounting, the discounted cash flow (DCF) equation, DCF appraisal, and three acceptable techniques for estimating a "discount rate" in the DCF method. The numbers used in the calculations are for illustrative purposes only. (2) The three acceptable techniques for estimating discount rates are: (A) market surveys; (B) oil and gas sales analysis; and (C) weighted average cost of capital (WACC), also called "band of investment." (3) Together, these techniques provide a range of discount rates. The appraiser must estimate the risk for each oil or gas property to assign a discount rate from the discount rate range. (4) Subsections (l) - (o) of this section (Appendices 1 - 4) provide examples to illustrate DCF appraisal, the WACC estimating technique, a standard deviation analysis, and a description of property specific risk factors. (d) Discounting. (1) Because investors prefer immediate cash returns over future cash returns, investors pay less for future cash flows--they "discount" them. The amount investors discount the future cash flows depends on the length of time until the cash is due, the amount of risk that the cash will not be tendered when due, and the rate of return available from other comparably risky investments. This discounting procedure converts future income to present value, usually using annual discount factors. The discount factor for each successive year declines to reflect the reduced value of revenue received in the future. The appraiser calculates the present worth of the forecast revenue stream by multiplying the projected net income (cash flow) for each year by the calculated discount factor for that year. These discount factors are derived from the discount rate (also known as the yield rate), and the process is known as discounted cash flow (DCF) analysis. (2) The International Association of Assessing Officers in Property Appraisal and Assessment Administration (1990) defines "discount rate" as: "The rate of return on investment; the rate an investor requires to discount future income to its present worth. It is made up of an interest rate and an equity yield rate. Theoretical factors considered in setting a discount rate are the safe rate earned from a completely riskless investment (this rate may reflect anticipated loss of purchasing power due to inflation) and compensation for risk, lack of liquidity, and investment management expenses. The discount rate is most often estimated by band-of-investment analysis or a sales comparison analysis that estimates typical internal rates of return." (3) The discount rate is a key variable in discounted cash flow analysis, making correct rate selection crucial. The market's expectations are critical when choosing a discount rate. According to the Appraisal of Real Estate by the Appraisal Institute (1992): "The selection of the yield discount rate is critical to DCF analysis. To select an appropriate rate an appraiser must verify and interpret the attitudes and expectations of market participants, including buyers, sellers, advisers, and brokers. Although the actual yield on an investment cannot be calculated until the investment is sold, an investor may set a target yield for the investment before or during ownership. Historical yield rates derived from comparable sales may be relevant, but they reflect past, not future, benefits in the mind of the investor and may not be reliable indicators of current yield. Therefore, the selection of yield rates for discounting cash flows should focus on the prospective or forecast yield rates anticipated by typical buyers and sellers of comparable investments. An appraiser can verify investor assumptions directly by interviewing the parties to comparable sales transactions or indirectly by estimating the income expectancy and likely reversion for a comparable property and deriving a prospective yield rate." (e) Discounted cash flow appraisal. (1) The DCF method is versatile and widely used to appraise income producing property. An appraiser using DCF first projects an anticipated net income for each year of the property's remaining economic life. Each annual cash flow is discounted to present value, and then all the present values are added to obtain the total market value of the real property interest being appraised. (2) The DCF equation is expressed as follows.
Attached Graphic (3) To estimate the present value (PV), an estimate of the income (cash flow) to be received in each period is necessary. The number of periods, n (usually years), used in the analysis is determined by the number of years that the mineral property is expected to produce a positive net income. (4) There are many variations on the DCF formula. The formulas vary based on the time the money is received, i.e., continuously, beginning of period, middle of period or end of period. The period may be continuous, daily, monthly, quarterly, biannual, or annual. Many oil properties are evaluated using an annual mid-period discounting variation of the DCF formula. The appropriate present-worth factor for mid-year DCF analysis is:
Attached Graphic (5) Subsection (l) of this section (Appendix 1) illustrates how a discounted cash flow is calculated, using a midyear factor, for a mineral property. (f) Discount rate components. (1) Components. The discount rate used in discounted cash flow analysis has several components. These include: (A) inflation rate; (B) risk-free component; (C) general risk premium; and (D) property-specific risk premium. (2) The inflation rate. The annual rate of price change for a basket of consumer goods. Inflation is normally measured by the Consumer Price Index for All Urban Consumers (CPI-U), calculated by the United States Bureau of Labor Statistics. The inflation rate is the most basic component of a discount rate. An investor's rate of return must equal the rate of inflation just to break even in real dollar terms. (3) The risk-free component. A return to compensate the investor for a loss of liquidity. This component can also be defined as the risk-free rate minus the inflation rate. The risk-free rate is made up of the inflation rate plus a return to reimburse the investor for a loss of liquidity and is measured by the yield to maturity on federal government securities with a maturity period comparable to the investment under consideration (oil or gas reserves in this case). The market perceives these securities as risk-free for all practical purposes since they are issued by the United States government. (4) General risk premium. (A) A return to compensate the investor for assuming diversified company-wide risk. The weighted average cost of capital (WACC) minus the risk-free rate is the general risk premium. The WACC is measured by weighting the typical oil company debt and equity costs by the typical oil company debt and equity capital structure percentages, and then adding the weighted costs. If one were appraising companies, the WACC would be the discount rate, since it reflects the market's expected yields from the stock and debt of a company. Calculation of a WACC will be explained in more detail later in this manual. (B) For property tax purposes, appraisers estimate the value of individual mineral reserves, not the value of oil companies. Buyers of mineral reserves usually perceive these individual reserves as riskier than the stock and debt of an entire company. Companies can spread their risk over many individual mineral reserves and often over several kinds of assets (some of which are unrelated to the oil or gas business). This asset diversification reduces the company's risk and, as a result, the WACC derived from company financial data is usually lower than an individual producing property's discount rate. However, the WACC is always higher than the risk-free rate. This increase in the rate is a general risk premium to reward investors for assuming the diversified company-wide risk. (5) Property-specific risk premium. A return that compensates the investor for assuming the unique risks associated with a particular mineral producing property. The discount rate minus the WACC is the property-specific risk premium. Investors demand a premium above the WACC to compensate them for this individual property risk. For certain high-risk properties, this premium can be quite high. See subsection (o) of this section (Appendix 4) for a list of property-specific risk factors. (6) Component summary. These discount rate components can be summarized: INFLATION RATE + RISK FREE COMPONENT + GENERAL RISK PREMIUM + PROPERTY SPECIFIC RISK PREMIUM = DISCOUNT RATE. (A) There are other ways to "build up" a discount rate. This method's advantage is that the first three components are quantifiable from public data. The property-specific risk premium may be derived from available data in some cases, but in general, the appraiser must estimate it. (B) Refer to subsection (o) of this section (Appendix 4) for mineral-property conditions that should be considered when estimating the property-specific risk premium. (g) Using the three techniques. (1) Components contained in the three techniques. (A) Market surveys and sales analysis result in rates that include all of the discount rate components. However, in these two techniques, the rate included for the property-specific risk premium is the typical rate for the properties included in the survey or sales analysis. The appraiser must estimate the property-specific risk premium (unless the sales sample is directly comparable to the property being appraised) and adjust for atypically high or low risk. This means that the appraiser must reduce the risk premium for properties with less than the typical risk and increase the risk premium for properties with more than the typical risk. (B) The third technique (WACC) produces a rate that does not contain a component for property-specific risk. Because it lacks this component, the typical WACC of potential purchasers sets a minimum value for a discount rate and the appraiser must calculate the typical WACC of potential purchasers to know this lower limit. On a case-by-case basis, the appraiser should exclude oil companies from the WACC calculation if they cannot participate in the market for the property he or she is currently appraising. For instance, small companies may not be able to bid on certain very valuable oil and gas properties because of insufficient capital. A typical WACC for larger oil companies would establish an appropriate minimum discount rate for appraising these properties. (C) An investor should not buy a property at a lower discount rate than his or her WACC, otherwise the investor's net worth will decrease. The appraiser must add the property-specific risk premium to the typical WACC of potential purchasers to develop a discount rate. See subsection (o) of this section (Appendix 4) for a list of property-specific risk factors. (2) Developing a range. (A) Ideally, the appraiser should use these three techniques simultaneously to develop a range of discount rates. The typical WACC sets the lower limit, while surveys and direct sales analysis provide a set of discount rates that the appraiser can use as a database that will help to estimate a midrange discount rate and an upper limit to the discount rate. Examples of these techniques can be found in subsections (l) - (p) of this section (the appendices). (B) Some mineral properties may appear to sell at or below the purchaser's WACC. There are several reasons that a mineral property may appear to change hands at a discount rate equal to or less than the WACC. When a buyer (or appraiser) reduces the cash flows to account for reserve recovery risk the discount rate will not reflect the risk, but the purchase price will. To calculate a discount rate that is comparable to discount rates from other sales, the appraiser must quantify the risk adjustment and add it back to the cash flows. This discount rate will be higher than the non-risk-inclusive rate. (C) Atypical income tax deductions, or abnormally high or low overhead can also create an artificially high or low discount rate. When faced with market evidence that would indicate a discount rate at less than a company's cost of capital, the appraiser should review all other appraisal parameters to determine why an abnormally low discount rate is indicated. An understated income stream is the most obvious reason. The appraiser may be able to adjust the cash flows and derive a market discount rate or may delete the sale from consideration. (h) Market surveys. Cont'd...