Discount Rates From Market Sales vs. Cost-of-Capital: From Whence Cometh the Difference?

Abstract

Abstract This paper will briefly discuss the derivation of market value discountrates from market sales and, separately, from cost-of- capital approaches. Thepaper will then focus on the reasons for the apparent disparity wherebydiscount rates derived from market sales consistently exceed, on an annualaverage basis, discount rates calculated from cost-of-capital. Studies doneover the period from 1985 through 2000 suggest that market value discount ratesderived from actual market sales average 22–25% Before Federal Income Tax(BFIT) while discount rates calcu lated using cost-of-capital methods forpublic oil and gas companies average 14–18% BFIT. These source-based differences in discount rates have been noted by authors and, more frequently, byusers of the data and are a significant source of controversy for those whorely on such data for the specification of valuation parameters. Four primarysources for the differ ence(s) which have been suggested are examined anddiscussed in the paper and in underlying, referenced research. These sourcesare:Specific Property Risk as compared to Portfolio Risk;Return-of-Investment not included in Cost-of-Capital;Reserve Risk inaddition to Specific Property Risk;the difference in Liquidity ofinvestments made in stocks and bonds as compared oil producing properties. Thepaper and the underlying work draw on previously published studies from thepetroleum evaluation and financial communities along with ongoing market salesdata studies to examine each area of difference in detail and attempt toquantify the effect of each on the market value discount rate. Introduction Evaluators of oil and gas properties, regardless of the purpose of theexercise, ultimately must decide which discount rate to use in estimating thevalue of the property. (Hereafter "oil" includes gas unless otherwise stated.)In many instances this decision is simplified by edict whether through companypolicy, govern ment regulation or client preference. The accuracy and appropriateness of discount rates from these sources may be debated but theindividual evaluator has little chance of imposing another choice. For thoseevaluations not covered by edict, which are arguably the majority ofevaluations, the person doing the work is the one who must determine which rateto use. Engineers trying to estimate Fair Market Value (hereafter "FMV" or "MarketValue") face a particularly difficult task. There are only two sources forreliable discount rates. The first is data from actual market transactions or"Market Derived" discount rates. Reports and studies which provide this information are limited in both number and coverage. Some of these studies do notprovide sufficient supporting information to allow the user to judge thequality of the conclusions. Nonetheless, market derived data does exist andthat data has application to market value estimation for all oil and gasproperties. The second source for discount rates is to calculate or otherwise determinethe "Cost-of Capital" which would be appropriate for an investment in petroleumproducing properties. The Cost-of- Capital ("COC") is a commonly used term thatis just as com monly confused with the cost-of-debt or, in the usual terminology, the "bank lending rate on oil loans." The use by some evaluators of thecost-of-debt in place of cost-of-capital is a fundamental error that causesserious misunderstanding of market valuation procedures. This distortion aside, the properly defined cost-of-capital is a powerful tool for beginningthe discount rate selection process and is, in fact, the basis for many of thediscount rate edicts contained in company policies and client preferences. Thecost-of-capital is not really a "cost" at all. When correctly calculated, thecost-of-capital for a company (or industry) is a measure of the return expectedby an investor on both the debt and the equity of a company, weighted by theappropriate proportions of each in the total funding. There are several goodsources for oil industry cost-of-capital information and for the foundationdata which would allow an evaluator to derive his/her own estimate of such arate.