| (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. (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. Cont'd... |
