Property Evaluation - A Return To First Principles
Authors: Capen E.C. 
Published: December 2007

A lesson from college physics: If you get lost, start over at F=ma (force=mass×acceleration). We can use that same strategy for property evaluation where similar first principles apply.

In a survey sponsored by the SPEE, respondents say they use discount rates of 20% or more. First principles tell us that the discount rate and the reinvestment rate should be the same. Using over a century of data, Siegel's STOCKS FOR THE LONG RUN shows that average returns for companies have been 5% after tax and after inflation. Not 20%. Either Siegel errs or respondents have no clue.

Consultants often raise discount rates to account for risks. Say the uncertainty for a project lies mostly in the cost to get production started. Raising the discount rate to account for cost uncertainty affects every yearly cash flow except the one with which we're uncomfortable. Initial investment remains virtually untouched by the higher discount rate. First principles tell us that discount rates measure time value of money, not risks.

Some analysts do FMV determinations failing to recognize the effects of competition. The identification and ramifications of the Winner's Curse enlighten us that a winning offer is not a reliable value estimate. First principles teach us that an auction winner because of his high side bias cannot claim to be "equally knowledgeable," a basic phrase to the FMV definition.

Misuse of the Capital Asset Pricing Model has mislead many executives into setting unreasonably high target returns. Academics signed on to a simple formula that they claimed captured the subjective investment decision making practices of a hundred million individuals. First principles inform us that no one has found such a formula because human behavior is unpredictable.

The paper describes these and a dozen other similar evaluation problems.

Introduction

Sometimes when confusion reigns, we should return to our roots. Go back where it all started. Examine first principles. I can think of few places where such a strategy would be more appropriate than in the valuation of oil and gas properties. Many of those who purport to dispense expert advice have no personal stake in the outcome though they may find some reward for supporting a particular view. No wonder lots of bad counsel gets spread around like so much fertilizer. One of the more egregious errors we find in oil and gas valuations today is 1) the confounding of risk, the potential for damage or loss, and 2) the discount rate which measures the time value of money. The first requires application of objective probability analysis and subjective tolerance for uncertainty. The 2nd leans mostly on objective criteria found in the public financial records of companies doing business in oil and gas.

We'll examine this problem as well as others that introduce errors into oil and gas evaluation. You should find a fully self-contained paper here. These pages hold all the evidence for all of the arguments. With this simple presentation of facts I would not expect any reader to bog down, require help from others, or retreat to the familiar, "well that's not the way I was taught."

In this paper I'm going to try to take care with the definitions. Risk means the potential or chance for loss.1 Uncertainty means a lack of knowledge about what the future holds. From analyzing uncertainty we uncover the effects and size of risk. Risk ? uncertainty.

Opportunity

Consider the following investment. You give me $40 dollars now. A disinterested 3rd party will activate a well balanced spinner with 3 equal colored segments. If the spinner's arrow head lands in the blue, you (or your heirs) win $100. If it lands in the red, you (or heirs) win $80. Otherwise you get nothing. The heirs come into play because the payoff occurs 6 years from now. Prudential guarantees payment via an arrangement I make with them should I not survive to fulfill my obligation to you. Moreover I'll agree to play this game with you every hour of the day so you don't have to face the so-called single opportunity problem.

We identify three distinct considerations. One, the uncertainty of whether or not the spinner lands in your favor and two, the time value of money since you must invest today for a possible payoff in 6 years. Risk? Yes, you may lose money.

Expected Value and Variance

When you have more than one possible outcome, you must spell out each or at least enough of them to get a good handle on the variability to expect. In this simple example you get either $0, $100, or $80. How does one describe such a game? You could say that it has the potential for a $100 payoff and make your decision on that basis. You could note that you have a 2/3 chance of winning and only a 1/3 chance of losing and make your decision accordingly. We know better ways.