Profitability Reports

(I process all inventory data with INFORM, a computer program that is capable of simulating all the ways that trees grow: volume, grade value and market value.  Data processing includes a financial analysis of treatments and future growth.  The following memo explains the terminology and assumptions used in these financial analyses, called profitability reports.)

Understanding Your YIELD-MS Profitability Report

INTRODUCTION

The performance of forestry investments is usually evaluated by measures of net present worth and internal rate of return.  These measures for your property are presented in the per acre profitability report at the end of your inventory, growth, and treatment data by YIELD-MS, the growth and treatment program of INFORM, an integrated system of forestry software programs.  The following will explain the meaning of these measures and what went into calculating the results for your property.  

NET PRESENT WORTH

Net present worth is the present value of future returns minus the present value of future costs.  It's possible to calculate the present value of a future return or cost by a technique called discounting.  Discounting is essentially the reverse of compounding.  To illustrate, if you estimate that you will need $1,000 in 10 years, how much money would you have to invest now at 6% compound interest to produce that $1,000?  The amount would be the present value of the $1,000 discounted at 6% compound interest. 

The discount rate for returns in the 10 to 20 year time frame are generally pegged to returns on treasury bonds of the same maturity.  At present, these rates are 6-8%.  But these rates include the anticipated rate of inflation for the time frame.  The real interest or discount rate for treasury bonds would be lower by the rate of inflation which is currently 3-4%.  This means a 3-4% real interest or discount rate. 

Your simulations are done in real, or net-of-inflation terms.  Inflation is not included in the simulations because it is so hard to predict.  I normally use a real discount rate of 6% in creating profitability reports because forestry investments are less liquid and less secure than treasury bonds.

If the rate of return earned by the investment is greater than the discount rate, the net present worth will be greater than zero.  If not, it will be less than zero.  Most owners are satisfied if their forest investments can grow faster than the discount rate.  This rate is easily achieved by most forest stands.

INTERNAL RATE OF RETURN

Internal rate of return is the rate of interest at which discounted returns equal discounted costs.  Returns are from sales of timber and land, although there may also be lease fees, tax savings, etc.  Costs include land and timber purchases, taxes, forester's fees, timber stand improvement, etc.  The internal rate of return assumes that the returns from sales of timber during the management period will be re-invested in the project.  This may be an unrealistic assumption where internal rates of return of the project are higher than those obtained from other investments.

COMPOSITE RATE OF RETURN

The composite rate of return assumes that returns from sales will be invested at the discount rate rather than the internal rate.  It is therefore a more realistic rate of return.  The composite rate of return is nearly always lower than the internal rate.

ANNUAL EQUIVALENT VALUE

Annual equivalent value is the net present value expressed as an annuity over the time period of the simulation.  It can be viewed as an annual bonus earned above the discount rate.  It is a useful measure for comparing investments of unequal length.  For instance, it might be useful in comparing the periodic returns of forestry investments with the annual returns of agricultural investments.

OTHER MEASURES

Your report also includes discounted benefit/cost ratio and soil expectation value.  The former is another measure of profitability for the time period analyzed.  The latter is the discounted value of presumed future returns on the same frequency--15 years in this case.  This measure is of course irrelevent to your simulation because the theoretical cleacut would remove all the timber and growing stock.   

UNDERLYING ASSUMPTIONS AND METHODS

Your financial analysis assumes that the present inventory value of timber and growing stock is the starting point or basis of the investment.  This is done in order to calculate the performance of the timber investment, even though you may not actually have that much invested in the trees--particularly if you've owned the land for some period of time. 

If the total initial investment in a forest property is divided among catagories of timber and growing stock, bare land, houselots and buildings, the actual investment in the timber is usually less than its full inventory value.  In any case, the latter value is the one used for your investment analysis.  This investment basis is depleted by the value of any initial thinnings or harvests and the balance is carried to the end of the simulation period as the adjusted cost basis

Chapter 61 taxes and forester's fees are added to the cost basis over the simulation time period.  Chapter 61 land taxes are added on an annual basis.  Chapter 61 stumpage taxes are added to the expenses of sales as percentages.  Fees may be for management planning, boundary work, timber marking and sales, etc.

At the end of the simulation period the stand or forest is theoretically clearcut to make the program perform its financial analysis.  The program divides the final net value by the adjusted cost basis to determine the present net worth, internal rate of return, and the other measures of profitiabiliy.  In reality, your forest stands will be partially cut again towards the end of the simulation period.

LAND VALUES

I separate the investment in land from the investment in timber because land values grow according to different and less predictable criteria.  For example, during the 1970's land values increased dramatically.  This was during a period of high inflation when other investments were less attractive.  Many investors bought land and other real property.  Increased demand forced land values up.  As inflation fell in the 1980's, investors took their money out of land and put it into stocks and bonds.  As a result, the value of land went down to the point where now in real (uninflated) terms it's at a 20 year low.

A future increase in inflation would probably cause land values to rise again.  But absent such an increase, they should stabilize or increase slightly from their current low levels. Houselot values are of course a different subject because there is much less land suitable for development.  The prices of houselots have continued to rise in real terms through the 1980's and early 1990's.

VOLUME INCREASE RATES

As trees grow in diameter and height, their volumes increase.  The 15 year simulation shown in your growth report is for the residual stand after the first cut.  It depicts how your forest will grow in basal area, Mbf, and cords per acre.  It also shows how the forest will grow in value (exclusive of market value increases--see below).  

Growth rates are influenced by species composition, stand age and site quality.  The inventory determines species composition.  Increment borings determine age and soil maps determine site quality.  The program adds ingrowth from trees too small to appear in the inventory.  It also deletes trees from the inventory according to predetermined mortality rates for different species.  Net total volume increase rates will generally range between 3 and 5% per year.

GRADE VALUE INCREASE RATES

After an initial thinning, improvement harvest, or shelterwood cut, most residual trees will grow about one inch in diameter every 5 years.  In my grading system, tree grades are based on 2 inch diameter classes and clearness of the butt log.  Therefore residual trees without serious defects will increase by at least one grade during a 15 year simulation. 

Grades were assigned to all the trees in your inventory according to my specifications.  As YIELD-MS grows your inventory, it increases grade and value of predetermined proportions of the inventory as they meet the diameter requirements for the next tree grade.

Since the unit value (per Mbf value) of high grade species increases by 50-100% with each increase in grade, the residual trees representing most of the value in a stand will nearly double in grade (unit) value every 15 years.  This usually translates to a 3-4% real grade value increase rate.  Lower value species will show lower rates of grade value increase.

MARKET VALUE INCREASE RATES

Different species have shown dramatically different rates of market value increase in recent years, including some very high rates for the more valuable species.  However, projecting these rates into the future may be overly optimistic.  A conservative estimate would put real market value increase rates in the range of 0-5%, depending on the species and grade, for the term of your simulation. 

SPECIES GROUP
GRADES 5 TO 1

REAL MARKET VALUE INCREASE RATES

SPECIES GROUP
GRADES 5 TO 1

REAL MARKET VALUE INCREASE RATES

       

Red Oak

2-4

Red Maple

0-2

White/Other Oak

1-3

White Birch/Beech

0-2

White Ash

1-3

White Pine

0-1

Black Cherry

2-4

Hemlock

0-1

Sugar Maple

4-6

Pruned Pine

2-4

Black/Yellow Birch

3-5

   

The table above shows anticipated `real` or net-of-inflation market value increase rates based on the performance of different species and grades over the past 10 years.  YIELD-MS printouts use the term `inflation` to refer to this factor.  However, the rates entered in the stumpage price module for your simulations do not include producer price inflation.

HOW TO VIEW YOUR PROFITABILITY REPORT

Although YIELD-MS is the most popular, and is among the most realistic programs available for forest growth and treatment simulations, it has one notable deficiency.  The deficiency lies in an inconsistency between the growth and financial analysis modules.  The growth module is incapable of projecting improved market conditions for timber, while the financial analysis module can. 

Calculations from the growth module--without market value increases--show up in the growth report and the lower half of the profitability report, while calculations in the upper part of profitabiliy report include whatever market value increase rates have been entered in the stumpage price module.

The upper part of the report shows `real` or net-of inflation profitability measures for your forest investment, including volume, grade and market value increases, plus management costs and risks.  The growth report and the transaction summary in the lower half of the profitabiliy report omit market value increases in their calculations of future values. 

To compare your forest investment with other, prospective investments for which returns are projected in producer price inflated terms, you should add a value for inflation to your forestry investment , or subtract it from the other investment.

Karl Davies
May, 1995