Timberland

What are Common Errors Made when Analyzing Timberland Investments? How Can We Avoid Them?

What are Common Errors Made when Analyzing Timberland Investments? How Can We Avoid Them?

We all make errors when analyzing forestry investments. How can we avoid them? Unsurprisingly, most errors relate to the data used – the inputs – or the math in the spreadsheet. Errors associated with inputs affect the cash flows in the analysis and, in turn, impacts our estimate of value. Specifically, in our work as analysts and in the work of clients and colleagues, we focus on and observe three major categories of errors in Excel models and spreadsheets.

First: Analytic Errors

We find that analytic errors in Excel are common. Of all of the spreadsheet models we review, approximately one-third have an error in a formula (that we find). Most often, these are associated with “relative” and “absolute” referencing, where a formula is pulling in data from the wrong cell or worksheet. Professor Ray Panko at the University of Hawaii, who actually conducts spreadsheet research, noted in a 2006 interview with the Wall Street Journal that “you’re going to have undetected errors in about 1% of all spreadsheet formulas.”

Second: Application Errors

Application errors reference issues with the thinking behind a spreadsheet, the formula chosen, the use of a formula, or a comparison made. For example, analysts commonly make mistakes with inflation by mixing real and nominal discount rates and cash flows. Also, spreadsheet models of forestry investments may inappropriately compare before and after-tax results and investments of differing duration (time periods). Finally, using the incorrect metric can be problematic, such as misapplying cash-on-cash return, pay back analysis and internal rate of return (IRR).

We typically find errors of this type when analysts are comparing timberland and forestry investments with alternative asset classes, such as stocks, bonds, agricultural commodities and commercial real estate. Historically, the day-to-day metrics for forestry differed in application, so a bit of time spent checking assumptions and thinking through the communication of results can be helpful.

Third: Errors of Omission

Errors of omission are especially problematic (and embarrassing). We work hard to avoid the situation of being asked “did you check _____?” and, if relevant, having to answer “No, we didn’t think of that.” Ugh. Unfortunately, we find that third-party spreadsheets often omit key facts or considerations, including relevant costs and potential revenues. Just as important can be confirming that the assumed costs and revenues are current and reflect the best available, accessible information.  In short, know what’s knowable.

Strategies to Minimize Errors

We observe and teach a few key practices in our work with clients to minimize the chance and occurrence of errors. First, we label tabs and worksheets, and date all files. That way, if we revisit a model several weeks or months later, we can retrace our steps and know what we’re working with. Also, if we correct an error or make another improvement, we know which version is the most current. Second, we try to set aside time to check each other’s work before sending results “out the door.” Admittedly, this is also the most challenging. We find that imposing and embracing milestones – midpoints for deliverables or reviewing work – throughout a project institutionalize a level of quality control. Finally, at the end of the day, we ask ourselves the question “where could we have blown this?” Some level of paranoia and self-awareness is required for quality analysis of forestry, or any other, investments.

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About the author

Brooks Mendell, Ph.D.

Brooks Mendell, Ph.D. is President and Founder of Forisk Consulting, a forest industry, timber REIT, bioenergy and timber market research firm. Dr. Mendell has over fifteen years of operating, research, and consulting experience in forest business and finance. Mendell has published over sixty articles and two books on topics related to timber and timberland REITs and markets, forest business management and operations, and communication skills.

1 Comment

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  • Forest investments create real analytical problems as DCF is the only way to handle irregular positive or negative cash flows. Many use the method when they really don’t have the information to correctly apply the technique.
    The lack of accurate inventory information and how to phase in product shifting or volume entrance when pre-merchantable stands shift into merchantable volume is a problem.

    As you mentioned real and nominal is commonly confused.

    The ability to prove the market IRR is difficult to support thus shifting the analysis via NPV.

    What is the inflation rate that can be factored out of a mystical nominal rate to derive the correct real rate? It ain’t easy folks!

    I have serious issues with any analysis related to perpetual rotations as most holding periods of investments is much shorter and more related to commercial holding periods. Closed in funds and refinancing or resale cause me problems with pie in the sky projections in perpetuity.
    The termination of the investment requires an estimate of the reversion or future sale of all the components in the last year cash flow. If real rates of appreciation are loaded in at optimistic levels the analysis becomes very sensite to such assumptions and can be a source of error. Fortunately the time value of money reduces error as the investment horizon is extended.

    The complexity of accurately estimating irregular and fixed expenses and revenues and then punting with an NPV that may or may not reflect the true character of the tract in its competitive market is a risk factor.

    In closing, I think an analysis on an after tax basis is chocolate cheese and may look good in a spreadsheet but is so tract and investment specific that it has little application in a market value estimate.

    I agree with everything you said in the article and know that some appraisers have little forest management understanding which adds even more error to the process when they attemp to value a complex forest asset.

    Good article!

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