Good practice application of the DCF valuation method
The DCF valuation method is commonly applied in the valuation of resource projects that are in development or production as at 1 May 2010.
Of all of the commonly applied resource valuation methods, good practice application of the DCF valuation method is arguably the most demanding in terms of the number of input parameters required, as well as the demands on the valuer to critically assess the reliability and suitability of the market-based and project-specific parameters that drive the valuation outcome.
These demands imply that caution needs to be taken when applying the DCF valuation method to early stage exploration and petroleum resource properties. This is because properties at these early stages of development have typically not been subjected to the analysis necessary in order to define project-specific DCF input parameters to a high level of confidence.
Project-specific input parameters for earlier stage development properties are likely to be more speculative in nature and are likely to be subject to a higher degree of uncertainty. Consequently, the ATO considers it to be good practice for valuers to reflect the degree of statistical confidence in the resulting valuation outcome caused by uncertainties in relation to input parameters. While not essential, this improves the level of transparency of the resulting valuation report.
The DCF derived market value of a resource project is highly sensitive to a number of critical input parameters, such that small variations in the assumptions adopted in relation to those input parameters can result in a wide variation in valuation outcomes.
The remainder of this sub-section describes the level of enquiry and transparency that the ATO considers to be good practice in relation to project-specific and non-project specific DCF valuation parameters.
Project-specific valuation parameters within the DCF valuation method
The ATO considers it to be good practice for valuers to critically evaluate the project-specific data and other information provided by the taxpayer (or otherwise obtained), and to undertake suitable checks, enquiries, analyses and verification procedures to ensure the integrity of the data relied upon. This includes (but is not limited to):
- the reliability of the stated reserves and resources as at 1 May 2010
- the development of appropriate field of development scenarios that reflect an appropriate level of resource-to-reserve conversion that can be reasonably expected to occur over the life of the project
- the development of production schedules that deplete reserves and an appropriate amount of resources over the life of the project
- the fixed and variable cost structure applied to the production schedule in order to forecast operating costs and capital expenditure over the life of the project under the various production scenarios considered, and
- taxes and royalties.
This level of good practice implies that valuers should have a good understanding of the extraction process and the technical inputs that underpin field development plans. Alternatively, it may be appropriate for valuers that do not have this level of understanding to seek advice from suitably qualified technical experts, which may include in-house experts where appropriate.
While valuers are likely to reflect varying degrees of detail in relation to fixed and variable cost drivers in their valuation models, the ATO considers it to be good practice that valuers adopt operating cost drivers and capital expenditure drivers that exhibit a strong relationship to the underlying physical parameters contained in the field development plan being valued. For example, fixed costs are typically driven by the nature and level of equipment required to meet the scheduled production task, as well as the number of production personnel required to operate and maintain the equipment. Variable costs are typically driven by the consumption of key consumable items such as (amongst others) electricity, gas, water and diesel. Building up fixed and variable cost and capital expenditure with a strong relationship to the underlying physical parameters will enhance the transparency and replicability of the valuation outcome.
The taxes that applied on 1 May 2010 must be used for forecasting future tax expenditure. All federal, state and local taxes which apply to the operations of the project must be taken into consideration. Tax expenditure on the extended PRRT cannot be considered as it was not announced until 2 May 2010. As the valuation is retrospective, any intervening events since 1 May 2010 must not be taken into account. For example, taxpayers cannot use the announced reduction in the company tax rate, as it was not known as at 1 May 2010. Royalty forecasts must reflect royalties that were in place on 1 May 2010, plus any publicly announced increases in royalty rates.
Commodity price forecasts within DCF valuation models
The ATO understands that many valuers develop forecast commodity prices with reference to a benchmark product, and then apply a number of adjustments to the benchmark product forecast price to account for, amongst other things:
- differences in quality between the benchmark product and the project product
- differences in the freight cost between the benchmark product and the project product, and
- other adjustments deemed appropriate.
The forecast commodity price adopted by valuers for benchmark products, and the adjustments made to these reference prices are material inputs into the DCF valuation of resource projects. As such, the forecast commodity price assumptions adopted when valuing resource projects represents a significant risk factor to the ATO in its administration of the extended PRRT.
In developing forecast benchmark product prices, the ATO considers it to be good practice for valuers to consider:
- the forward prices for benchmark products available in the financial markets as at 1 May 2010
- an appropriate analysis and discussion of the drivers impacting long term prices
- a method of transitioning between short-term and long-term price assumptions, and
- a range of forecast scenarios (extreme values or outliers would be avoided when presented with a potential range of values).
The ATO recommends that valuers apply a high degree of transparency in arriving at the commodity price forecasts adopted in their DCF valuation models. In addition, the ATO considers it to be good practice for valuers to identify the sensitivity of the valuation outcome to uncertainties in the commodity price assumptions adopted, and to take this into consideration when adopting the chosen market value of the project.
Exchange rate parameters within DCF valuation models
The exchange rate assumptions adopted by valuers are material inputs into the DCF valuation of resource projects. As such, the forecast exchange rate assumptions adopted when valuing resource projects represent a significant risk factor to the ATO in its administration of the extended PRRT.
In developing forecast exchange rate assumptions, one method is to give consideration to the forward exchange rates or consensus forecasts evidenced in the financial markets as at 1 May 2010.
However, forward exchange rates and consensus forecasts may only be available for a limited period of a project's life, particularly if project reserves and resource imply a project life well beyond five years after 1 May 2010. For this reason, it is likely that valuers will need to develop a mechanism to generate forecast exchange rates to cover the full life of a project.
Forward exchange rates that are able to be evidenced in the financial markets typically mirror those that are able to be calculated using the uncovered interest rate parity method of forecasting exchange rates. As such, the ATO considers that it may be appropriate for valuers to forecast exchange rates with reference to the uncovered interest rate parity method.
The ATO also understands that another method to forecast exchange rate assumptions is to rely on the foreign exchange market. That is, the current exchange rate is a good estimation of the exchange rate over the forecast period.
The ATO considers it to be good practice for valuers to clearly identify the method used to forecast exchange rates. The ATO also considers it to be good practice for valuers to identify the sensitivity of the valuation outcome to uncertainties in the exchange rate assumptions adopted, and to take this into consideration when adopting the chosen market value of the project.
Relationship between exchange rate parameters and commodity prices
The method used to forecast exchange rate parameters will have to be consistent with the commodity price curve adopted. This is because there is a strong relationship between exchange rates and commodity prices in the Australian market.
Discount rate parameters within DCF valuation models
The discount rate adopted by valuers is a material input into the DCF valuation of resource projects. As such, the discount rate parameters adopted when valuing resource projects represents a significant risk factor to the ATO in its administration of the extended PRRT.
One of the primary drivers of the discount rate is the 'levered beta' adopted when applying the capital asset pricing model (CAPM). The levered beta takes into consideration the debt structure of a hypothetical buyer, whereas 'beta' itself does not.
When calculating the levered beta, the ATO considers it to be good practice for valuers to:
- clearly identify the comparable listed companies used to estimate the beta parameters, including an analysis of the selected companies to indicate the reason for their inclusion within the cohort of comparable companies
- explain the method of calculating the levered beta and unlevered beta for each of the selected comparable companies
- give consideration to the statistical significance of the beta parameters determined for each of the selected comparable companies
- clearly explain the extent to which they relied on the beta analysis undertaken to arrive at the final beta parameters adopted, and
- give consideration to the fact that upstream and downstream projects may have different betas.
Due to the fact that many exploration and early stage projects are either not operationally or financially successful, the ATO considers it to be good practice that valuers reflect this risk in the discount rate adopted.
Inflation rate parameters within DCF valuation models
DCF valuations can be undertaken in either real dollars (by applying a real discount rate), or in nominal dollars (by applying a nominal discount rate). The ATO considers it good practice to articulate which method (real or nominal) has been used.
Valuations undertaken in real dollars may require a real-to-nominal dollar adjustment in order to correctly calculate the tax shield on depreciating assets. The ATO also considers it to be good practice for valuers to clearly identify the reference date to which real dollar input parameters relate.
If valuations are undertaken in nominal dollars, the ATO considers it to be good practice for the underlying revenue, cost and capital input parameters to clearly identify the changes to parameters based on inflation and those changes based on other considerations. Doing so will enhance transparency in relation to the underlying input parameters being adopted.
DCF valuation model structure
In order to enhance the transparency of the valuation outcome, the ATO considers it to be good practice for valuers to develop DCF valuation models that are well structured, including:
- that the model logic flows from top-to-bottom and from left-to-right
- that all input parameters are grouped together (possibly in one sheet) and clearly separated from calculations
- that intermediate calculations are undertaken in a simple and logical manner, and
- that each intermediate calculation is only undertaken once rather than multiple times in different locations within the model.
While valuers are likely to reflect varying degrees of detail in the build-up of their cash flow models, the ATO considers it to be good practice for valuation models to include:
- a breakdown of third party revenue by product type (to the extent that the project produces multiple products with distinctly different commodity pricing characteristics)
- details of the calculation of the transfer price used to arrive at the resource revenue at the taxing point or the value of downstream intangible assets
- a break-down of the major production cost items along the value chain (for example, the cost of undertaking extracting, transporting and processing activities)
- movements in inventory that impact the cost of sales
- the depreciation and amortisation profile of major capital items that impact the calculation of cash taxes
- project overhead costs
- an allocation of corporate overhead costs, where appropriate
- the cash tax payable on operating profits taking into consideration the consumption of tax losses and the taxable income as a result of depreciating the existing tax base of assets
- the amount of cash required to support the operations, including sufficient cash to cover the operating risk inherent in the project
- inventory balances
- accounts receivable and accounts payable balances
- the plant and equipment balance for major asset categories that reflect their depreciation and capital expenditure profile, and
- the cash payment profile against deferred liabilities such as employee provisions and rehabilitation provisions.