More and more Australian agricultural businesses are seeking capital for expansion or looking for exit options. As this trend continues, and the sophistication of investors entering the market continues to rise, the methods used to value agricultural assets are becoming increasingly important to ensure business owners can attract professional investors.
For some time there has been a wide held belief that the comparable sales methodology is the only method available to value agricultural properties, but BDO’s experience has highlighted inherent limitations in applying this methodology.
A key limitation is the sole focus on the price someone else recently paid for a similar property to inform investment decision making. A basic principle for successful agriculture investment is to ensure a purchaser buys at the right price. It might be that the price someone else has paid for an agricultural property proves to be inflated for a wide range of reasons and yet this is the price being used as the basis for valuing another asset. A further limitation is difficulties in finding comparable sales as it is important the valuation takes account of different production capacities, levels of development and development potential. Our interaction with the sector and professional investors interested in gaining exposure to it has shown an increasing trend towards methods that consider earning capacity of the asset, such as Discounted Future Cash Flows (DCF).
The DCF methodology calculates the value of an entity by adding its projected future net cash flows discounted to their present value at an appropriate discount rate. The discount rate is usually calculated to represent the rate of return that investors might expect from their capital contribution, given the riskiness of the future cash flows and the cost of financing using debt instruments.
In addition to the periodic cash flows, a terminal value is included in the cash flow to represent the value of the entity at the end of the cash flow period. This amount is also discounted to its present value. Any surplus assets, along with other necessary valuation adjustments, are added to the DCF calculation to calculate the total entity value.
In the case of a beef enterprise the key inputs required to estimate future cash flows may include herd structure, weaning rates, mortality rates, stocking rates over time with development (if the opportunity is available), weight gains, beef prices, operating costs, and capital expenditure (including expenditure required to increased production capacity). As a result, the valuation would reflect estimates of the specific cash flows generated by a particular business.
Importantly, such methods are not only more relevant in certain sale situations (such as those when comparable sales in the area are not available), they are also permissible under Accounting Standards in certain circumstances.
In the case of a business combination, the value assigned to the identified assets of an agricultural business under Accounting Standard AASB3 is required initially to be reported at fair value. Fair value is defined by the new Accounting Standard AASB13 Fair Value Measurement as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
The Accounting Standard further specifies that “An entity shall use valuation techniques that are appropriate in the circumstances and for which sufficient data are available to measure fair value, maximising the use of relevant observable inputs and minimising the use of unobservable inputs". The standard notes that the three widely used valuation techniques are the market approach, the cost approach and the income approach. Thus, in cases where the income approach, for example DCF, is considered the most appropriate, accounting standards require it to be the approach adopted.
Further support from Accounting Standards for the use of an income approach in certain circumstances can be found under AASB 136 Impairment of Assets. This standard requires a reporting entity to ensure its assets are carried at no more than their recoverable amount. The term “an asset” applies equally to an individual asset and a cash-generating unit. The Standard defines recoverable amount as the higher of an asset’s or cash generating unit’s fair value less costs to sell and its value in use. Fair value can be determined as discussed above. Value in use is calculated by estimating the future cash flows and applying an appropriate discount rate to those future cash flows applying the specific requirements of the Standard.
An earnings based valuation approach can result in improved ongoing management of businesses because the financial model developed to estimate cash flows can help guide future decision making.
BDO commented on this issue in the Australian Financial Review (17 March 2013 – page 33 and online). The article is also available via Farm Online and Stock & Land.
To find out more about how agricultural businesses can best approach earnings-based valuation, contact a BDO Food & Agribusiness expert.