In this first part of a two part series today and tomorrow, Brisbane based accountant and property valuation professional Michael Vail steps through the process of valuating pastoral land, comparing the calculations of five different approaches to the task, while also explaining the difference between a Walk-In Walk-Out (WIWO) value and a BARE-basis value.
“It was the best of times. It was the worst of times.” (With apologies to Charles Dickens)
I speak, of course, about the two investment values of Market Value (i.e. Price), and Fair Investment Value, which rarely agree. However, they should be understood, especially in the context of valuing, for investment purposes, a going concern (with ‘all things necessary’), Walk-In Walk-Out, ‘as-is-where-is’, grazing enterprise in the Pastoral Zones of Australia.
A few days ago, a long-term colleague and friend of mine, and I were discussing the two current states-of-play, where cattle prices are as high as they have ever been due to quality supply shortages, yet a great pall of drought lies hard upon the land; with 75pc of Queensland officially ‘Drought Declared’.
We also discussed what that might mean for medium term pastoral grazing land market values (ie Price), with the prospect of an El Nino possibly worsening the outlook for graziers by extending an already bad, crisis type scenario; and placing Equity Capital at extreme risk of loss.
After thinking about the scenarios which might play-out, I decided to step through a valuation task (as an example to those who may wish to do the same for real), comparing the calculations of five appropriate, yet different approaches to the task; whilst also showing the difference between a Walk-In Walk-Out (WIWO) value and a BARE-basis value.
The problem currently is that properties are being offered on a BARE-basis (i.e. Land & Improvements only), but the vendors are expecting a WIWO price – possibly guided by ignorance, greed behaviours, and the ‘blind-leading-the-blind’ approach of Comparative Sales Analysis; where “the property down the track achieved ‘$X’, therefore so should I”. Not much critical thought there.
If the Buyer pays the expected price, then she has paid a near 55% premium for the privilege, and still only bought the Land & Improvements; whilst then having to spend/invest that premium again, to purchase the Stock and Plant necessary to become a going-concern: and the land, stock, and plant is subject to GST on transfer, as it is not the sale of a going concern, and ‘with all things necessary’.
WIWO is understood to be a sale of a going concern (with ‘all things necessary’), ‘as-is-where-is’ approach; sometimes, and in some minds, this may be interpreted as a BARE-basis. Very convenient: but impossible!
For this exercise, I have assumed a hypothetical grazing property at Augathella, in central western Queensland, and the background for the valuation case follows.
Background: ‘Value’ versus ‘Price’
Pastoral property is an asset.
Like all assets it has a Value, and a Price; which rarely agree.
Value is an economic construct about future expectations, whereas Price is reality; being the final accepted bid in a sales transaction.
Value is like a 200-day moving average trend-line, looking through a rolling 10-year cycle; a smoothing of the long-term data, if you will.
Price is a line joining points representing sales transactions, around that long-term trend-line, showing the demand for that asset set against supply, and therefore reflecting availability of credit through the boom and bust phases of a business cycle.
As credit becomes more available, more is borrowed to compete for scarce resources/assets, and as competition increases, so too does the asking-price for those assets.
After a period of time, the prices paid may go beyond a point (especially in thinly-traded markets, like quality pastoral properties) where Full, ‘True’, or Intrinsic value may be found; based upon Fundamental Analysis.
Once this occurs without a mean-reversion to trend (or value-line) then prices paid change from being an investment, with an appropriate return-on-investment (ROI) or margin-of-safety (MOS) in the decision, to a situation of high-risk speculation.
Remember if too much is paid for an asset which has proved to be a great business in the past, it may remain a great business; just a poor investment.
Whilst you must put Capital at-risk to grow wealth, you must protect your Capital.
Financial assets or instruments are the easiest to value and place a price upon; because the ‘rules’ are common, and well-known to all stakeholders and participants; and there is volume and liquidity in the size and frequency of trades (e.g. shares, bonds, bank bills, and commercial debentures).
Residential and Commercial land in the city is bought and sold every day; so price discovery in those instances is not a problem.
Other assets, such as specialist property (e.g. pastoral grazing land) is not so often traded, and these markets may have poor price discovery, due to the thin-trading situation.
The next issue to focus upon after the difference between Value and Price, is the Risk/Return trade-off.
We touched on return-on-investment (ROI) earlier, and this is only a generalist metric to measure, and compare. More specific metrics are return-on-equity (ROE), return-on assets (ROA), and/or return-on-capital-employed (ROCE). Also, very specific indices may be generated (e.g. using Kg.(Meat) / Ha. / mm. (Rain) x (ex ) to measure on a scale of 1 to 10).
The most important point is an understanding of measuring a return, and maybe comparing it to some benchmark that is industry best practice.
Thereafter comes expectations of each measurement: “Compared to what?” If you can measure it, you can improve it.
The established literature around the Risk/Return trade-off theory is deep in the consciousness, knowledge, and understanding of the finance and investment community, both personal and corporate; if only markets were really efficient.
The main part to understand is that risk and un-certainty are two different things; risk is naming the event, which may happen, and un-certainty is the likelihood, on a scale of zero to one, this event may actually occur.
The risks which attach to the value, and therefore Capital, of an asset should be identified, measured as to size of likely effect, and a risk-weighting allocated to reflect the likelihood of that event occurring.
The next step is to understand that risks do not stand alone: all risks are cumulative.
The higher the expected risk of loss of Capital, the higher the expected return necessary to compensate for that risk.
In a very broad-brush fashion, we may commence to combine the above factors into the pricing of an asset. For instance, valuing a company’s share, listed on the ASX, and traded every working day, 230-days of the year. If it is an Industrial Stock, it will pay dividends (coupons) maybe twice a year. If we imagine this scenario and calculate either our personal opportunity cost-of-capital, or likely expected Yield-to-Maturity (YTM) for the stock (i.e. company) going forward, we may capitalise this semi-annual cash-flow to derive an expected value to compare with the market spot-price now.
For example: Very simplistically, if the semi-annual dividends were $0.20 per share (and there is no expectation that dividend policy may change for the foreseeable future), and the YTM is 0.12 (or 12%) then the expected value today is ($0.20 + $0.20) / 0.12 = $3.33 per share. If the asking price on the ASX screen is less than this price by more than twice the cost to transact, then Value is greater than Price, and it is a buying opportunity; hoping to make an arbitrage profit when the general market catches-up to your advanced thinking and expectations.
Your thinking may also prove to be incorrect; because this process is about future expectations!
Definitions and Thoughts
A few things to be aware of, and to recall often, are:-
- Price is what you pay; and Value is what you get: and,
- You make your money when you buy, not when you sell;
so, do not pay too much beyond a Fair Investment Value at the outset, if a premium is demanded.
A definition of an Enterprise Value (EV) for any going concern business which is not a ‘micro’ business (i.e. Revenue less than $ 1.0-mil.), might be:-
- “Any income producing asset is viably worth no more than the expected future Net Cash-Flows (looking through a 10-cycle), discounted at an appropriate interest rate (or hurdle rate of investment return) which fully reflects all identifiable risk factors; faced both every day, and in the ‘tail’: unless there is a very compelling and rational reason(s) to do otherwise.”
- An income producing asset is one which has a positive net income, is not continually loss-making, and has growth in top-line revenue. Many micro, and some small business in this space are not positive for profit or cash-flow, and probably should be valued on some other appropriate basis, like ‘Cost-to-Create’ (Hayes 2011). The question remains whether this type of property is, or ever could be, a going concern; due to lack of scale, quality of resources, or is it just poor management? Buy quality assets, or burn Capital.
- EV is defined as the ‘whole of business’ Asset Value, less any Surplus Assets, like Cash. It is an ‘all-Equity’ model, assuming NIL debt. If any Debt exists, then it may be deducted from EV to arrive at a value for total Equity (i.e. which is important if you are only buying a Controlling share of Equity, rather than 100%; and different again, if you are buying a Minority interest with little power to influence decision-making).
The Problem in Search of a Solution
“What exactly is the problem?”; I almost hear you ask.
The problem is, a complete disconnect between the economics of a grazing enterprise, and the prices being paid for what is essentially a high-risk, food and fibre operation, open to the vagaries of commodity market spot-prices, and the fickleness of the weather.
We have recently experienced a mean reversion, or return to long-term trend, over the past four years, since the crazy high prices of the period 2004 to 2011; with prices coming back 30% to 50% depending upon where a property was situated. However, because the methods being used to ‘value’ grazing properties were being incorrectly applied, combined with a change to selling (read, ‘stripping’) assets from properties, rather than offering them WIWO as a going concern, made one feel we were back in the dark Privateer days of Gordon Gecko, and the “Barbarians at the Gate”. Which proves the point that asset prices had breached ‘bubble-land’ and were being exploited. Human nature…
Of course, for a transaction to take place, there had to be someone else seated on the other side of the table; and a vast amount of Buyers’ investment Capital went to the wall: especially when considering the legally tax-driven Agricultural Schemes offered by Great Southern Plantations, amongst others.
The Questions to ask
“I keep six honest serving-men, (They taught me all I knew);
Their names are What and Why and When, and How and Where and Who.”
- Rudyard Kipling (1902).
For anyone approaching the task of buying any asset, let alone the scale of a pastoral grazing enterprise, one must step through a process, first asking “Why?” it is the correct decision to make; to arguably make the biggest investment decision of your life, predicated on a possibly emotional platform, rather than remaining objective and emotionally detached throughout the decision-making process. This first step may save you, not only your Capital, but also your emotional well-being.
Ask, “Can I afford this investment, considering the risks, and with a margin-of-safety?”
The framework within which to assess the correctness of any investment decision is to focus on the expected risk factors, and ask ‘what would a prudent person expect as an appropriate Return-on-Investment (ROI), considering the cumulative effects of the risks being taken?’.
If the answer(s) to the first question stack-up, then please proceed to the next important array of questions:
- Does the idea/investment make sense: using a feasibility study/business plan?
- How will you fund the idea/investment; savings, equity, or debt?
- For Succession & Estate planning purposes, how will I structure the asset for best long-term effect; legally, financially, and operationally?
Other questions which should be answered in turn may be:-
- What is the future Demand for my end-product? Will it continue? At what level?
- Is growth expected?
- Am I a supplier of a commodity, and therefore a price-taker; or am I adding value to a raw material, towards satisfying a niche market, and therefore a Price-maker?
- Unless I am operating a Stud (selling genetics), I am in the food and fibre business (i.e. meat and wool): how will I maximise both quality and quantity of production, to achieve best practice?
- Based upon my current circumstances, how much can I afford to borrow; and what is the largest quality property I can afford?
- Will I rent/lease, then buy; or buy outright; and where?
- What are the robust assumptions I will make for my business case and modelling?
- As I will need to complete an annual Risk Management Statement (RMS), what are the multitude of risks I will face in this business (i.e. both internal and external); and what are their likely size/effect, and probability of occurring?
- How will I price, insure against, and mitigate these risks; remembering that all risk factors are cumulative?
- How will I mitigate against drought?
- What is the worst that may happen in a crisis; prepare a TOWS or SWOT Analysis?
- As I will need to prepare Cash-Flow budgets, along with pro-forma Balance Sheets and Profit and Loss Statements going forward (monthly for the first year, and annually for the following two years), what sensitivity measures will I use, and to what size and range, to understand ‘best’ and ‘worst’ case scenarios?
- What is an appropriate ‘margin-of-safety’ (MOS) to apply to my decision-making?
- If I worked for someone else, considering what I am best at, or was indifferent in my choice, what is the minimum I (and my Partner) could earn as wages (before tax)?
- If I left my Capital in the bank, and/or invested it in an alternative asset class, what return would I expect for the risk involved?
- If I add the results of the two items/questions above, this is my opportunity cost to Labour and Capital; and therefore the minimum Operating Profit/EBIT I should expect from this investment, to be indifferent as to proceeding or not. Is this the case?
- This then leads to the concept of a ‘Living Area’: how much does my family need? In an earlier article https://www.beefcentral.com/production/what-is-a-living-area-these-days/ (Vail 2012) I showed what is a living area nowadays. It was never about the area, but about what could be produced from a unit of land; and the answer for me, with a 10.0% margin-of-safety, was a self-replacing beef breeding herd of around 2,200-Head of Cows. In the context of a property in Central Queensland where the AE Sustainable Stocking Rate (SSR) through the cycle is around 1:14-Acres, the area required is around # 65,000-Acres. Read the article, and then plug and play your own story into the approach to see your circumstances and the size necessary. Does your target property fit this profile? Is it different? How? Why?
- What are my Accounting, and more importantly, my Economic Break-Even Points (for Price and Quantity) for my level of activity?
- What is my required rate-of-return, discount rate, or hurdle-rate, to apply against expected Cash-Flows, to achieve an economic profit; and be able to pay dividends (to take investment Capital off-farm), whilst leaving investments in the firm to fund future growth and to replace assets as they expire? My actual return must be above this figure; else it may be a net-sum-game of $NIL. For a going concern pastoral grazing enterprise, it should fall in the range between 14.50% and 33.33%. What is your rate?
- Once I have stepped through the above questions as a mini-Due-Diligence (DD) exercise/feasibility study, I must ask myself, “What is the most I am prepared to pay in Dollars per Unit of Area (DUA), an amount within my Cap-Ex budget, and still allow me to achieve my goals?” A normal Premium, in this thinly-traded market-place, appears to be between 3.0% to 20.0%; depending on Supply and Demand.
This list is non-exhaustive. What are some of your own questions to ask?
Remembering that you should never pay more for an asset than a multiple of the amount it will return to you, year-in year-out; before taxation, before the cost of debt, and after an appropriate pricing-in of the risks faced. For it is this amount which allows the investor to live, raise a Family, fund and pay-back Debt Capital, replace assets, and to invest in future expectations.
Based upon my experience, any other view is mere folly!
You may think about an asset with income, like a tradeable Corporate Bond; with the property being the asset Capital, or ‘Tree’, and the income being the annual harvest, or ‘Fruit-of-the-Tree’.
In the context of a going concern grazing enterprise, in the pastoral zones of Australia, the quality of the Tree is a function of the environment/location and the climate; looking through the cycle. The fraternal twins of production economics, being Quantity and Price, are combined to provide the Fruit-of-the-Tree (or Coupon), looking through the cycle, and is also a function of environment/location and climate.
‘Price’ is the Investment Value today. ‘Face Value’ is the amount paid last time the property was sold. ‘Term’ is the period of time between that date and today.
Capital growth long-term, is around 2.5% to 5.0%, and Yield/Coupon (income) is mostly between (20.0%) and 20.0%; with only around 20.0% of all enterprises achieving the higher Net Profit. Some have a higher profit again, and some are perennially ‘broke’.
Further in the context of a going concern grazing enterprise, in the pastoral zones of Australia, an appropriate pay-back period is assumed around a maximum of less than 7-years (if an ‘all-Equity’ position), and ideally less than 5-years (if Debt funding will oscillate around 20.0% Debt to Assets) for most Small/Medium/Large (SML) private businesses with Revenue less than $100.0-million (AUD); unless the business is pregnant-with-profits, and throwing-off regular cash-flow in excess of an above average Return-on-Equity greater than 15.0%; else the Price/Earnings Ratio is showing expectations of ‘better things to come’.
Further work has refined these likely maximum multipliers down to around 5.6-Times, if an ‘all-Equity’ position, and around 4.7-Times if Debt will be around 20.0% (+/- 20.0%) Debt to Assets.
These ‘times-years’ are the multiples of Operating Profit/EBIT which may be applied to reach an Enterprise Value (EV).
For Due Diligence (DD) to occur, even in small part, the hurdle is convincing Vendors that you will require the previous 10-years of signed-off Financial Statements and Income Tax Returns; albeit you are happy to preserve privacy by signing a ‘Non-Disclosure, Confidentiality Agreement’ in their favour. Without the data, how may you make an informed decision? Else, it is all hypothetical, and therefore riskier; and a higher discount rate should be applied to the decision.
TOMORROW: A PASTORAL VALUATION, AND CONCLUSIONS
The author Michael J. Vail, M App Fin, M Prop Val, F Fin, CTA, FCPA, is a director of TRE PONTE Corporatein Brisbane . He can be contacted by email by clicking here
To read previous articles on Beef Central by Michael Vail, click here