| (1) An appraiser may use market surveys as an indicator of the discount rate. Many studies and surveys are published to help the appraiser estimate an appropriate discount rate or range of rates for appraising oil and gas properties. The Society of Petroleum Evaluation Engineers' (SPEE) Annual Survey and the Western States Petroleum Association's (WSPA) Analysis of Oil and Gas Property Transfers and Sales and Derivation of a Band of Investment are good examples. (2) The SPEE survey asks producers', consultants', and bankers' opinions on future prices, cost escalation and economic indices (including the discount rate) used in petroleum property evaluation. (3) The WSPA study, conducted by Richard J. Miller and Associates, consists of two parts: an analysis of oil and gas property transactions and sales occurring in California from 1984 through the current year and an analysis of the weighted average cost of capital (WACC) or "Band of Investment" of a representative group of companies for the same years. The WACC analysis is based on public data. (i) Developing a discount rate from sales. (1) Basic steps. To develop a discount rate from sales requires three basic steps: (A) obtain recent sales prices from a variety of oil and gas producing properties; (B) develop cash flow projections for each property; and (C) calculate the internal rate of return (IRR) for each sale. This is also known as the discounted cash flow return on investment (DCFROI). (2) Sales sources. Information about sales can be obtained from a variety of sources, but the best source is the buyer or seller. Other sources that list sales of oil and gas property include the Texas Railroad Commission, Oil and Gas Journal 300, Strevig and Associates, private firms and oil and gas companies. It is important to remember that the sale of an oil or gas property must be a market transaction when developing a discount rate from sales. (3) Cash flow projections. After obtaining verified sales prices, the appraiser develops cash flow projections for each property. To the extent possible, the appraiser must talk with the parties to each sale to determine their expectations of the property and take those into account when making projections. The validity of the derived discount rate is a direct function of the amount of information obtained from the buyer and seller about their cash flow projections. The appraiser must incorporate this information into his or her projections. If the appraiser's projections differ from the buyer's and seller's expectations, the discount rate derived from the sale will be invalid. (4) Calculating the IRR. (A) The third step in developing a discount rate from sales is to calculate the internal rate of return (IRR) for each sale. The IRR is the yield (discount) rate at which the present value of a cash income stream equals the present value of the cash expenditures (the sales price in our analysis) necessary to produce that income stream. This discount rate is prospective; it does not depend on the historical performance of the property, but on the market participants' expectations of future performance. The discount rate at which the present value of the cash flows equals the sales price can be determined by trial and error. However, there are several calculators and personal computer software packages that can solve for the discount rate (IRR). (B) Although computational procedures may vary slightly, this measure is also referred to as the profitability-index and investor's method. The IRR recognizes that funds received now are more valuable than those received at some future time. The investment outlay can be regarded as borrowed funds and the pre-tax cash flow as the payment of principle plus compound interest on the investment. (j) Weighted average cost of capital. (1) Definition. A widely used method for deriving a pre-tax base discount rate for valuation purposes is the band of investment, or WACC technique. The basis for this analysis is the financial data from a broad sample of oil companies that derive a majority of their operating revenues from oil and gas production. Since petroleum property valuation typically involves discounting cash flows over a long period of time, a long-term cost of capital is most appropriate for developing an oil or gas property discount rate. Thus, the appraiser should incorporate a broad time series of data to approximate a long-term cost of capital. (2) Required calculations. Four sets of calculations are required to determine the WACC. (A) The typical capital structure is derived and expressed as a proportion of debt and equity. (B) The typical cost of outstanding debt is calculated based on bond yields. (C) The typical cost of equity is computed using the Capital Asset Pricing Model (CAPM) or another method such as the DCF Model. (D) Debt and equity costs are weighted according to the typical capital structure percentages and added to derive a typical cost of capital. (3) Capital structure. (A) "Capital structure" describes in percentage terms the sources of funds (capital) used to purchase the assets necessary to operate a company. The capital structure of any company consists of debt and equity. The debt portion consists of long-term debt (represented by outstanding bonds) and preferred stock, while the equity portion consists of outstanding common stock. If the company is funded by debt and equity of equal value, the capital structure is 50% debt and 50% equity. (B) To estimate a discount rate for mass-appraisal purposes, the appraiser should use the typical market capital structure for a representative group of major and independent oil companies that derive a majority of their operating revenues from oil and gas production. (4) Cost of debt. The yield-to-maturity is the best approximation of the cost of debt capital. This yield is observable in the marketplace and can be found by referring to Standard and Poor's Corporation Bond Guide, Moody's Bond Report, or a comparable publication. (5) Cost of equity. (A) The CAPM is the preferred approximation of equity cost since it considers both historical market yields and current expectations, plus a market-derived equity risk factor. The CAPM method measures the cost of equity by considering that an investor's required rate of return on common stock is comprised of a risk-free return plus a risk-adjustment factor related to the specific stock. This is represented by the following equation: K = Rfc + B(Rm - Rfh) where: K = cost of equity (after tax), %/year; Rfc = current risk-free rate, %/year; Rm = historic market return on equities, %/year; Rfh = historic market return on long-term government bonds, %/year; B = BETA coefficient. (B) The current risk-free rate (Rfc) is typically based on current long-term government securities, i.e., the yield-to-maturity observed on an annual basis on a default-free treasury bond, note, or bill of the relevant time period. For oil and gas property appraisal, the yield on a long-term bond is an appropriate measure of the risk-free rate. (C) The historical market return on equities (Rm) on common stocks and the historical arithmetic mean on long-term government bond income returns (Rfh) can be obtained from Ibbotson Associates' Stock, Bonds, Bills and Inflation. The beta coefficient (B) measures market risk by regressing the stock's total return against the market's total return. A more detailed description of the beta calculation can be found in the Ibbotson Associates report. The beta coefficient value can be obtained from Value Line Publishing, Incorporated's The Value Line Investment Survey, Standard and Poor's Corporation's S&P Stock Reports and similar investment services. (D) The difference between the historical risk-free (Rfh) and market (Rm) rates of return is a measure of the non-systematic or non-market related risk caused by changes specific to the companies comprising the stock rate of return sample and is, in effect, an equity risk premium. Note that two different risk-free rates of return are used in the CAPM. The current risk-free rate (Rfc) is used to acknowledge the expectational function of the model. The historical risk-free rate (Rfh) is used in conjunction with the historical market return for the same time period when calculating the equity risk premium. (E) The cost of equity resulting from this model is a nominal (current dollar) after tax rate. Conversion to a nominal, pre-tax rate requires dividing the equity cost (K) by one minus the federal statutory income tax rate for petroleum companies. The income tax rate is presently 35%. This is represented by the following equation: K(pre-tax) = K/(1 - .35). If the appraiser calculates a typical effective income tax rate from a representative sample of petroleum companies that could participate in the market for the property that he or she is appraising, the appraiser may substitute that typical effective income tax rate for the statutory rate. (6) Weighting debt and equity costs. Cont'd... |
