Financial theory is based on the assumption that money has Time Value. The idea is that a dollar available to you today is worth more than a dollar available to you later. The mechanics are fairly simple:
- Borrowers will pay interest to get money now and repay it later.
- Lenders will be paid to give up money now and be repaid later.
Time Value (Discounted Cash Flow) calculations are used to determine the cost or reward. Following the financial crash of 2008, the concept that money has “Time Value” has been somewhat turned on its head. The Federal Reserve has maintained what has become a 0% interest rate policy since the crash, which effectively makes borrowing to the most “prime” borrowers free, and lenders not being paid for providing capital.
Since 1981, declining interest rates contributed to inflation in the stock market and real estate. As interest rates fell, investors “bid up” the value of income streams.
Compounding this inflation has been an increasing amount of debt used in the capital structure of many investments and companies. Almost all real estate transactions were financed with at least 80% debt. When markets began correcting in 2008 (that is, values of assets began falling) it became clear that real estate values could decline by 20% or more. Given that 20% equity in real estate was considered “strong” the prospect of real asset values falling by more than 20% was catastrophic. It would have led to most real estate loans being greater than the underlying collateral value. This would have led to the insolvency of many financial institutions, as well as material collapses in the value of pension and insurance company portfolios. Similar collapse was faced by many companies with high levels of debt in their capital structure.
Ben Bernanke, the chairman of the Federal Reserve (“The Fed) at the time, took what was probably the only rational course by materially increasing liquidity in the system and materially decreasing interest rates. This resulted in a rapid re-inflation of property and other asset values, thus ending the crisis.
However, as often happens at the end of a long-term cyclical trend, the Fed (likely encouraged by the Treasury Department), has kept this policy in place ever since. For the Fed, it is like a “free lunch, increasing asset values at no cost (although it came with no underlying fundamental growth). An additional bonus from the perspective of the nation’s largest borrower (the U.S. government) is that it dropped the cost of borrowing materially, which was attractive during a period of rapidly expanding deficits.
During this current cycle, the Fed appears to have altered its priorities. Rather than the historical mandate of maintaining price stability, many of the governors are focused on maintaining the growth of investment markets. They appear to have accepted the idea that forcing investors to take more risk in order to earn yield was the way to do it.
The perversion in all of this is that those who contributed to the collapse in 2008 prospered from this new policy, while those who “did the right thing,” particularly those who had saved and not over-borrowed, bore the brunt. Wall Street and the big banks prospered. Retirees and others living on savings could no longer earn any return on their savings without materially increasing their risk exposure. John Mauldin published an excellent article on this topic on October 9, 2016.
Valuing Investments – the Financial Theory
If you studied this in college, skip this section.
The concept of Time Value of Money is extended into valuing equity investments. As in the case of a borrower and a lender, investors give up money today by investing it in exchange for the expectation of receiving one or more payments totaling a greater amount in the future. Valuing the uncertain future returns is performed using the concept of Discounted Cash Flow (cash flow being the investment returns paid to the investor).
The value of the Discounted Cash Flow is the Present Value. If one knows the amount invested and the amounts and timing of the receipts in the future, one can calculate the Rate of Return on an investment.
Financial academia has stated Present Value of an equal and the Net Present Value of unequal payments over time in algebraic terms as follows, Net is added to present value to reflect the change in the math to include the payment of the initial investment in the formula.
Looks complicated, doesn’t it! But it is not. I will attempt to restate this in plain English in the next section.
Valuing Investments – the Financial Theory
Here is a plain English explanation of Discounted Cash Flow. If one knows the amount invested and the amounts and timing of the receipts in the future, one can calculate the Rate of Return on an investment. Based on the estimated amount and timing of Future Earnings, the Present Value of those earnings can be calculated using the assumed Rate of Return required by an investor.
Following is an example:
Investor’s required Rate of Return (i.e., Discount Rate) 10%
Future Value(i.e., Payment from Investment to be received 1 year from today) $110
Present Value of Investment Today $100
If the investor invests $100 today, and actually receives his investment of $100 back in a year plus $10 in profit, he will have made 10% on his money ($100 * 10% = $10 + $100 = $110).
To calculate Net Present Value (that is, to calculate the value of an uneven series of payments over time), you do this calculation for each payment to be received over time and add them together. All financial analysis programs and spreadsheets perform this function.
This simple arithmetic is the basis of financial theory, and it is what all of the Greek formulas and algebra above say. This calculation underlies almost every investment evaluation I have ever seen. All of the financial terms used to describe the components – Net Present Value (NPV), Internal Rate of Return (IRR), Discounted Cash Flow and a number of others – describe an attempt to solve for one of the three variables based on assumptions about the other two.
Determining The Discount Rate
Financial theory then attempts to explain how the Discount Rate should be determined. Broadly stated, the discount rate should be as follows:
Discount Rate = Risk-free Rate + Inflation Rate + a Risk Premium
For example if the Risk-free Time Rate is 4%, the Inflation Rate is 1% and the Risk Premium is 5%, the Discount Rate used to value the future stream of earnings would be 10%. The calculated Net Present Value is the amount that would result in the return from the investment equating to a 10% yield.
Example in Oil Properties
We use Discounted Cash Flow to value oil properties. To calculate future cash flow we estimate future production volume, make an assumption on future prices by year, and subtract our estimates of future expenses per year. We then calculate the present value of each income payment expected to be received using an appropriate Discount Rate.
Fifteen years ago, the Discount Rate used to value mature, fully developed producing properties was around 12%. Backing into the Discount Rate calculation above, we can calculate the Risk Premium as follows:
Risk Premium = Discount Rate – Risk-free Rate – Inflation Rate
So if the:
- Discount Rate = 12%
- Risk-free Rate = 6%
- Inflation Rate = 2%
then the Risk Premium must have been 4% (12% – 6% – 2% = 4%).
It is easy to see how applying this logic led some during the energy boom to decrease their Discount Rate in valuing oil and gas properties into the single digits. If the:
- Risk-free Rate = 0%
- Inflation Rate = 0%
- Risk Premium = 6%
a Discount Rate of 6% is calculated. (0% + 0% + 6% = 6 %).
If an investor buys properties using a 6% discount rate, and borrows 60% of the money to make the purchase at 2%, he can then generate a 12% Return on Equity.
Looks pretty good in an environment of 0% interest rates. But there is a flaw in this “relative return” logic.
What Happened to the Oil & Gas Industry?
During the last decade many of our competitors decreased their discount rates into the single digits. In order to maintain high yields, they borrowed money at low interest rates to achieve yields on equity higher than the return from the producing properties. As I discussed in the prior two issues of The Producer, this combination proved deadly. As oil prices dropped in half, cash flow from producing properties decreased by 75% or more.
Most producing properties continued to generate positive cash flow before debt service. But this is partly because some of the investment is being liquidated every day. However, if oil prices over the next five years average lower than $80-$100 per barrel, which is now widely accepted, many properties will never generate enough cash flow to pay off the debt.
The error made by many investors over the last ten years was assuming that oil prices would remain high. Some argued that “Peak Oil” would result in decreasing supplies outside the U.S. Others argued that the high cost of shale development would create a “floor” for oil prices, and that prices could not fall below the floor.
But oil and natural gas are commodities. They do not behave any different than any other commodity. When supply is tight or decreasing and demand is constant, prices rise. When demand is constant or decreasing and supply is increasing, prices fall.
“Absolute return is the return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation, expressed as a percentage, that an asset, such as a stock or a mutual fund, achieves over a given period of time. Absolute return differs from relative return because it is concerned with the return of a particular asset and does not compare it to any other measure or benchmark.”
We are Absolute Return investors at Five States. We believe that the appropriate unleveraged return for owning producing properties is in the 9%-12% range. We therefore use this metric regardless of changes in the risk-free rate. We believe that this is the only way to be a rational value investor in this crazy economy. As the market for oil and natural gas prices continues to rationalize, we are once again high bidder in some cases. Frustratingly, in several recent asset sales in which we were the high bidder, the sales have not closed.
Patience is the most difficult virtue in value investing. But in strange times like these, sticking to fundamental discipline is the only investment methodology that makes since. We believe strongly that financial markets will rationalize, and that oil and gas markets already are doing so. We continue to review hundreds of assets each year for possible acquisition by our funds. We saw a large number of assets that we are interested in owning over the last three months. We have been high bidder on several of these assets, but the sellers are still holding out for more. So they have not sold. As the market rationalizes, market prices for producing properties are approaching our fundamental valuations. Our peers who are long-term investors, with whom we “compare notes”, are holding the same valuation metrics. As the market continues to rationalize, we expect to be able to make the best acquisitions of producing properties we have made in over a decade.