The disparity between current valuations of agricultural land and agribusinesses, and associated income generating capacity, is limiting the amount of external equity capital available to the agricultural sector, which is staring down the barrel of a huge capital gap.
The Australian Farm Institute, a farm policy research think-tank, recently published an article in the Winter 2016 edition of the Farm Policy Journal, entitled “The Valuation of Agricultural Assets in Australia.”1 The article, written by Tim Lane, National Director, Rural of valuation firm Herron Todd White, proposes a case for comparable sales valuation methodology and the difficulty with undertaking income based valuations of agricultural land and agribusinesses.
Sitting on the other side of the table, working with private and corporate investors seeking exposure to agriculture, through AMC’s joint venture with private equity asset manager, M.H. Carnegie & Co., I am hesitant to accept that there is no viable way to undertake income based valuations of agricultural land or agribusinesses. When seeking to invest in a business, rather than a straight real estate transaction, developing a detailed understanding of the revenue streams, enterprise profitability, free cash flow and return on tangible assets forms the basis of enterprise value.
Why should agriculture be viewed differently to any other asset class? Investors and owners should treat it the same.
Agricultural land and associated businesses are largely over-valued compared to alternatives
According to ABARES2, the financial performance of farm businesses, excluding capital appreciation, ranged from 0% to 2.3% average rate of return across all commodity sectors. How can the enterprise value of agricultural land and the business on the land, appreciate with flat revenue growth and languishing returns? The Top 25% of primary producers delivered a superior return on capital of 10.11% average from 2007 to 2014 so maybe only their properties should accrue more value?
For example, and as referenced by Lane, the average return on capital for Western Australian broadacre farming land was 3.37% from 2007 to 2014, and the land was valued at $1,100 per hectare over the same period. Assuming purchasing the business as an ongoing concern, and an Earnings Before Interest and Tax (EBIT) of $37 per hectare, based on the return on capital, that value represents an EBIT multiple of 29.7 times, a valuation far in excess of other asset classes with higher profitability. Hypothetically, if a sector agnostic, professional investor applied an EBIT multiple value of 10 to 12 times EBIT, equivalent to infrastructure, (see Table 1) to a WA broadacre farming business, they may pay between $370 to $444 per hectare for that land and associated cash flows.
Another example of valuation relative to profitability of an asset is REA Group, the market leading digital media business specialising in property (realestate.com.au). REA Group has annual revenue of $554 million, EBITDA of $310 million and an estimated enterprise value of $8.2 billion, representing an EBITDA multiple of 26.5 times. Accounting for Depreciation and Amortisation, the EBIT multiple for REA Group may be slightly different, but the point remains. REA Group, with an EBITDA margin of 55%, represents infinitely better value than WA broadacre farming land at 29.7 times with slim margins. How is a WA broadacre farming business worth more than REA on an EBIT multiple basis?
Table 1: Valuation comparisons to other “alternative assets”
Source: AMC – M.H. Carnegie & Co. market research of publicly available information.
Australian banks rely on comparable sales valuations
Australian banks rely on comparable sales valuations for agricultural land and the underlying security positions. This methodology results in a higher, more stable value that is not linked to the underlying profitability or income generating capacity. As a result, agricultural assets become unaffordable and unattractive to investors as there is a disparity between asset value and earnings.
If banks changed the underlying valuation methodology, there would be a reset of agricultural land values, loan-to-value ratios and perhaps a rethink on credit policy as values would readjust to a level reflecting the true income generating capacity of the asset… just like any other asset class.
The Australia and New Zealand Valuation and Property Standards outline the valuation standards related to the comparable sales methodology of valuing agricultural properties. If you were just buying the real estate without an associated business, there may be a case for comparable sales evidence, although the vast majority of investors and farmers are seeking to invest in an enterprise that generates profitable revenue streams and are valuing the future cash flows.
Investors almost always use an income based valuation approach when purchasing a business
In the article, Lane states, “Valuers often only have limited access to vital information like farm performance data, seasonal conditions, commodity price fluctuations, buyer motivation, and locational advantages or disadvantages. As a consequence, a valuer can find it quite challenging to apply a capitalisation rate for investors, and give them indicators of potential investment returns that are utilised commonly in the corporate investment world.”
The article continues, “This approach [Income approach] is rarely, if ever, used.”
Whilst the income based valuation approach is “rarely, if ever, used” within the industry, the income based approach is almost always used by professional investors and should be used by anyone looking to acquire agricultural land and the associated business. If the agricultural sector seeks to welcome investment capital, then it needs to understand the investment methodology. Investors take a detailed view on financial results, operational performance and the underlying assets, to determine the enterprise value, often engaging industry experts to assist in a detailed due diligence process.
As with most proprietary investments, data and information may not be presented in a manner intended for investor due diligence so time is required to request, gather, prepare and present the information. Analysis and further questions generally follow, and may happen over a couple of rounds. In my experience, the data required to make an informed investment decision is available, or can be determined, which allows investors to come to a conclusion on the enterprise value.
In response to the claim that seasonal variation and prices make it difficult to forecast income, throughout the due diligence process, investors will forecast likely return on tangible assets, internal rate of return, capital at risk and potential return on capital invested at sale. These forecasts make adjustments throughout time for various volatility scenarios. It is possible to model agricultural production variability throughout the supply chain and generate financial forecasts, in the same way it is possible to forecast the performance of a pub or airport. As with any forecasts, they are likely to change and have associated sensitivity analysis which show the impact of price, throughput or yield volatility.
Investors want to see what total returns can be generated through a combination of cash distributions and the terminal value upon sale. In addition to a return on capital invested, investors also seek to understand the return on any capital expenditure and the accretive effect on revenues. Earnings and margin growth are key drivers to investment performance and should therefore be accounted for in all valuations.
If an investor is purchasing an agribusiness as an ongoing concern, and not simply purchasing the real estate, the earnings, profitability, growth and security of revenue margins are critical to the success of the investment. Professional investors will not invest in a business simply on comparable sales evidence without critiquing earnings and profitability, nor should they.
The valuation of a business as an ongoing concern, or enterprise value, includes the value of land, improvements and the business including fixed and non-fixed plant and equipment, business licences, working capital and goodwill.
According to PKF3, the enterprise value assumes that there is a normal level of working capital required to deliver the projected earnings, which for agriculture, could include trade debtors, livestock or crops, inventory and trade creditors. Working capital represents the assets required in the ordinary course of business. In some cases, surplus assets such as property or investments are added to the enterprise value.
Valuations may limit available capital to agribusiness
In the current investment climate, direct alternative asset investors have a wide range of options representing value, growth and profitability. The capital can and will go elsewhere if investors do not see fair value.
Lane sums up the situation well, “Overall it is hard to show a clear correlation between investment return and land values on a year in, year out basis.”
“…the job of interpreting value through drawing conclusions through correct comparison techniques (which only comes with experience) is very subjective. Valuation is referred to as an ‘inexact’ science.”
Regardless of methodology, the value is what the market is willing to pay. As long as there are investors willing to purchase agricultural land based simply on comparable sales valuations, the valuation methodology won’t change, and land values may increase, although land based primary production will struggle to attract the larger pool of investment capital required to achieve the productivity increases to prosper in the future.
The fact is, investors acquiring businesses as an ongoing concern, conduct due diligence, and rigorous modelling on earnings, growth and profitability to determine enterprise value, and do not rely on comparable sales valuations. Investors and other buyers should utilise industry experts to understand the core drivers of business earnings and growth.
Unfortunately, those who stand to lose the most are in control of the process… the banks. Nobody is willing to stick their neck out, notably the valuers… Perhaps the system needs a reset.
It’s not just investors standing on the sidelines, aspiring farmers cannot afford to buy land at current values due to poor debt serviceability of the underlying business. There is also an impact on succession planning because the next generation is assuming inflated values, potentially over-capitalised assets and other family members only see the price tag, without fully understanding the underlying profitability or ability to successfully fund the succession transfer.
Due to the disparity between agricultural land valuations and income generating capacity, AMC and M.H. Carnegie & Co., are not currently seeking to invest in primary production assets. We choose to focus on core services to agriculture, infrastructure and operating real estate where the emphasis is on the operating business on the real estate, and valuations are linked to the earnings and profitability of the business.
1 Lane, T (2016), The Valuation of Agricultural Assets in Australia, in Farm Policy Journal, vol. 13, no. 2, Winter 2016, pp. 1-11, Surry Hills, Australia.
2 ABARES (2011), Australian Farm Survey Results 2008-09 to 2010-11, ABARES, Canberra, Australia.
3 PKF Pty Ltd (2016), Purchase Price Adjustments, in focus | on corporate finance, issue 15, p. 2, Sydney, Australia.