Building a Cap Rate Study

Transcription

1 Building a Cap Rate Study How Could Anything Go Wrong? Robert F. Reilly Willamette Management Associates Chicago, Illinois rfreilly@willamette.com (773) Keith Fuqua Colonial Pipeline Company Alpharetta, Georgia kfuqua@colpipe.com (678)

2 This presentation will provide an overview of the process of developing a unit valuation capitalization rate ( cap rate ) study. We will discuss some of the more complicated elements of the process and what you, the analyst, need to consider. We want to encourage interactive discussion among those in attendance. We want to give anyone who wants to build their own cap rate an analytical framework to consider. So let s get started!!! 2

3 Our format will have Keith assume the role of an analyst who is building a cap rate study for the first time. As moderator, Robert will assume the role of the independent valuation advisor who helps navigate Keith through the process. We would like the audience to participate as much as you want. So, please ask questions and provide comments as we go. We realize that this topic deserves a 4-hour seminar. So this discussion will be a general overview of how the cap rate development process works. Hopefully, this format 3 will be both informative and interesting.

4 Consider the objective of the valuation analysis Develop the appropriate capital structure Develop a cost of debt rate component Develop a cost of equity rate component Arrive at a final capitalization rate conclusion 4

5 Before we begin the quantitative or qualitative cap rate development analysis, we should understand the valuation assignment: What is the unit of operating property subject to valuation? What is the valuation date? What is the appropriate standard of value? Do we need to develop a yield capitalization rate or a direct capitalization rate? What is the level of income that we will capitalize in 5 our valuation?

6 Is there any statutory guidance, judicial precedent, or administrative ruling in the subject taxing jurisdiction that we (the taxpayer, the taxing authority, or the independent analyst) have to comply with? How do the answers to the above questions affect our selection of: the appropriate industry? the appropriate capital structure? the income tax rate? the expected long-term growth rate? the consideration of flotation costs? other cap-rate-related valuation variables? 6

7 Selecting comparable companies to use in the cap rate analysis Do we use Value Line, Standard d & Poor's, or some other data source? What criteria will we use to both select and reject potential comparable companies? SIC code Key word search Not penny stock Size Comparative Not an acquisition Geography profitability target Pure play Active trading Same income tax consideration Not in bankruptcy status 7

8 How do we define the subject company industry? By SIC code? By some other measure? Are we selecting comparable public companies or guideline public companies? Is there a difference between comparable companies and guideline companies? If so, how does that affect the other procedures in the cap rate analysis? 8

9 Are the comparable company selection criteria the same for this income approach procedure as they would be for a market approach (say, stock and debt method) analysis? Does it matter which data source we use to select the comparable companies? Is our selection criteria documented? Is our selection criteria replicable? Do we also have a documented rejection criteria? 9

10 Bloomberg FactSet MergentOnline Pitchbook S&P Capital IQ Thomson ONE 10

11 We want to select companies that do exactly what our subject company does: move refined petroleum products. For example, we want to select Buckeye, Plains American, Plantation, Explorer, Express, Platts, Keystone! The problem is that many of these operating companies either (1) are just a small part of a much bigger corporate structure or (2) are privately held like our subject company! Therefore, our selected comparable companies end up being a blend of liquids lines and companies that 11 operate liquids lines.

12 Based on our selection criteria, our selected comparable companies follow: Buckeye Partners, LP L.P. NYSE:BPL Enbridge Energy Partners, L.P. NYSE:EEP Enterprise Products Partners LP L.P. NYSE: EPD Holly Energy Partners L.P. NYSE:HEP Magellan Midstream Partners LP NYSE:MMP NuStar Energy L.P. NYSE:NS Plains All American Pipeline, LP NYSE:PAA Sunoco Logistics Partners, LP NYSE:SXL 12

13 13

14 Capital Percentage of Cost of Weighted Component Capital Structure Capital Average Debt 35%?????? Equity 65%?????? Total 100%??? 14

15 Do we select the industry average capital structure? Do we select the industry median capital structure? Is there a reason to select a mean versus a median? Do we consider the subject company capital structure? Do we consider the most comparable company capital structure? 15

16 Do we round the selected capital structure? How does our rounding convention affect our final cap rate conclusion? How do we document the selection of the appropriate capital structure? t Is that capital structure selection process replicable? 16

17 Next, we want to consider what the market tells us about our selected comparable companies and about their respective costs of debt. Let s consider the reported cost of debt data from S&P Compustat and Mergent 17

18 18

19 19

20 Different data sources indicate different costs of debt capital for the same comparable company Do we rely on only the public companies considered in our capital structure analysis? Or, do we rely on a broader industry sample of comparable companies? Do we select a mean or a median cost of debt? Do we select the cost of debt of the most comparable companies? 20

21 Do we consider the subject company cost of debt capital? Do we round the selected cost of debt capital? Are all of the public company bonds actively traded? Are all of the bonds from public companies that have the same income tax status of the subject company? How do we document the cost of debt selection process? Is that cost of debt selection process replicable? 21

22 Capital Percentage of Cost of Weighted Component Capital Structure Capital Average Debt 35% 5.84% 2.04% Equity 65%?????? Total 100%??? 22

23 Bloomberg Bonds Online Mergent Bond Record SEC EDGAR database (guideline company financials) S&P Capital IQ (guideline company financials) Thomson ONE (guideline company financials) Value Line 23

24 Determining the equity portion of the overall cap rate is generally considered the hardest part of building a capitalization rate. Which cost of equity method(s) should we rely on? Do we use the DCF model, build-up model, CAPM, MCAPM, or some other generally accepted model? Do we use a more theoretically robust--but less wellknown method (e.g., Fama French 3 factor model, Fama French 5 factor model)? What beta should we select? 24 Are there other factors that we need to consider?

25 25

26 Do we use the same comparable companies that we selected for our capital structure analysis? Do we use a broader (say, SIC composite) industry beta metric? Do we use the industry large composite or the industry small composite to reflect our subject company size? Do we consider the subject company beta? Do we use a mean beta or median beta? Or, do we consider the betas for the most comparable companies? 26

27 Is the beta for each comparable company equally reliable? (Or, are some betas influenced by inactively traded stocks, penny stocks, etc.?) What method do we use to unlever and relever beta? The Hamada adjustment? Some other formula? Do we round the selected beta? How do we document our beta selection? Is our beta selection process replicable? 27

28 Bloomberg Compustat S&P Capital IQ Value Line Duff & Phelps Valuation Handbook: Industry Cost of Capital (for industry betas) Barra Beta Book 28

29 29

30 30

31 31

32 Cost of Equity - Ex Poste CAPM Calculation Debt Preferred Equity Levered Relevered Weight Weight Weight Beta Beta Selected data for Subject (Value Line beta) 35.0% 0.0% 65.0% Eti Estimated tdcost of fequity 986% 9.86% Debt Preferred Equity Levered Relevered Weight Weight Weight Beta Beta Selected data for Subject (Bloomberg betas) 35.0% 0.0% 65.0% CAPM Long- After-Tax Cost of Equity: Horizon ERP Supply- Side ERP Relevered beta Market risk premium 5.80% 5.10% Beta-adjusted industry risk premium 5.16% 4.54% Add: Risk-free rate: normalized return on long-term Treasury bonds 4.00% 4.00% CAPM cost of equity 9.16% 8.54% Size risk premium 0.91% 0.91% MCAPM cost of equity 10.07% 9.45% Long- Horizon ERP CAPM Supply- Side ERP After-Tax Cost of Equity: Relevered beta Market risk premium 5.80% 5.10% Beta-adjusted industry risk premium 3.50% 3.08% Add: Risk-free rate: normalized return on long-term Treasury bonds 4.00% 4.00% CAPM cost of equity 750% 7.50% 708% 7.08% Size risk premium 0.91% 0.91% MCAPM cost of equity 8.41% 7.99% Estimated Cost of Equity 8.27% 32

33 Cost of Equity - Ex Ante CAPM Calculation Debt Preferred Equity Levered Relevered Weight Weight Weight Beta Beta Selected data for Subject (Barra beta) 35.0% 0.0% 65.0% CAPM Single- Merrill D&P Stage DCF Multi-Stage Lynch Est. Conditional After-Tax Cost of Equity: ERP DCF ERP ERP ERP Relevered beta Market risk premium 9.50% 7.58% 7.10% 5.00% Beta-adjusted industry risk premium 12.32% 9.83% 9.21% 6.48% Add: Risk-free rate: normalized return on long-term Treasury bonds 4.00% 4.00% 4.00% 4.00% CAPM cost of equity 16.32% 13.83% 13.21% 10.48% Size risk premium 0.91% 0.91% 0.91% 0.91% MCAPM cost of equity 17.23% 14.74% 14.12% 11.39% Estimated Cost of Equity 12.61% 33

34 34

35 35

36 What risk-free rate term do we use? 90-day Treasury bill? 10-year Treasury bond? 20-year Treasury bond? 30-year Treasury bond? What risk-free rate date do we use? Spot rate (as of the valuation date)? Average of last, say, 90 days? What general equity risk premium do we use? 36

37 What adjustments to the basic CAPM do we make? Size risk premium adjustments What size decile do we select? How do we justify the selection of a size risk premium? Does our selection of a size risk premium bias the income approach value indication? Company-specific risk premium adjustments t What company-specific factors do we adjust for? How large of a company-specific adjustment do we make? How do we justify the selection of a company-specific risk 37 premium?

38 Is the CAPM different from the MCAPM? When is it appropriate to use which model? How does a significant range of cost of equity indications affect the final selected cost of equity capital? Do we round our cost of equity capital estimate? How do we document the cost of equity capital selection process? Is that cost of equity capital selection process replicable? 38

39 39

40 Capital Percentage of Cost of Weighted Component Capital Structure Capital Average Debt 35% 5.84% 2.04% Equity 65% 14.00% 9.10% Totals 100% 11.14% 40

41 Should we adjust the cost of capital for flotation costs? Adjust debt capital cost only? Adjust equity capital cost only? Adjust both capital costs? When is it appropriate to adjust the costs of capital for flotation costs? Are there other procedures that would consider the flotation costs other than adjusting the costs of capital? 41

42 How does cap rate component rounding convention affect the precision of the final cap rate conclusion? Can we add significant digits to the final cap rate conclusion after rounding earlier in the cap rate analysis? Are we concluding a yield capitalization rate or a direct capitalization rate? Do we need to adjust our capitalization rate for Do we need to adjust our capitalization rate for an expected long-term growth rate? 42

43 How do we select (and justify and document) the expected long-term growth rate? Is the selected long-term growth rate different for a unit valuation than it is for a business valuation? Is the concluded capitalization rate consistent with the measure of income that we will apply it to? 43

44 The selected capitalization rate should be consistent with the purpose and objective of the analysis including the unit of operating property subject to taxation. The selected capitalization rate should be consistent with the income metric to which we will apply it. The selected capitalization rate should be consistent with any required statutory authority, judicial precedent, or administrative ruling. 44

45 We should acknowledge that the selected capitalization rate will be influenced by the experience and judgment of the individual valuation analyst. That said, the selection (and rejection) of the individual valuation variables and the selection (and rejection) of the cost of capital measurement methods should be documented. Through that documentation, the capitalization rate selection process should be transparent and 45 replicable.