For Sale or Lease

Interested? Don't worry about original construction cost, replacement value or asking price. More importantly, do not “bid in” your ability to generate more profits than the current owner.

Higher hog prices in recent months have some pork producers rethinking their exit strategies, while others are readying their business plan for expansion, pondering the “fair market value” of production facilities being offered for sale or lease.

Whether a buyer or seller, the true market value can only be established by what the facilities can earn after all costs are paid — excluding the cost of the facility, states Ohio State University economist Allan Lines.

“The fixed and/or variable costs of the current owner are not part of the equations. What the current owner ‘wants’ is not relevant to the question and should only be viewed as identifying the field where the game is being played,” he adds.

One more thing: “It is important not to bid the results of better-than-average management into the value of the facility,” Lines says. Buyers, sellers and lenders must resist the temptation to “bid in” greater productivity when evaluating the facility's worth.”

Using a farrow-to-finish operation as an example, Lines says if you focus on the earning power of recently constructed facilities, it is soon clear that such facilities, relative to the cost of constructing them, are not worth very much.

“Whereas, it may cost as much as $3,000/sow to construct new facilities, this analysis suggests that facilities with an expected life of five years would only be worth between $400 and $500/sow. Increasing the expected life to 10 years might increase the value to only about $800/sow,” he explains.

“The value of the facilities under consideration is a function of many variables; some are under the control of the prospective buyers and others are not,” he continues.

Lines' methods for determining fair market value may seem a little unorthodox by some, but he ensures they more accurately reflect what happens in the “real world.”

Line's equation — returns minus all costs except for the cost of facilities — is straightforward, but it's not as simple as it appears.

The Value Equation

Some of the more common methods used to determine value have little or no bearing on the production or fair market value, Lines says.

Popular methods for assigning value include recent, comparable sales; original cost minus depreciation (used for buildings recently constructed); and replacement value minus depreciation (used for older buildings that would not be rebuilt “as is” but include more modern technologies).

“These methods focus on a ‘remaining value’ as a function of cost and deterioration, rather than on what net return or profit the facility can be expected to generate,” Lines notes.

Problems often arise when a person's desire to produce hogs override the simple, sensible economic “use value” equation: Profit = Receipts — Costs.

However, the “derived value” equation determines what is left after all costs are paid (except buildings/facilities): Value = Receipts — Costs (excluding buildings). Some refer to this value as value-in-use, residual value or contributory value.

Naturally, the value of a set of facilities will differ depending on location and other factors, according to the buyer's/lessee's/renter's needs.

“A clear understanding of the economic concepts and decision-making principles that are central to determining the value is crucial in the process of determining the fair market value,” Lines says.

He outlines four critical concepts central to establishing fair market value — risk, receipts, costs and capitalization.

#1 Risk

“Before launching into the determination of receipts and costs, the decision-maker must recognize and plan to incorporate the element of risk in the calculation of value,” Lines cautions.

The big risks — prices (products, inputs) and animal performance (feed efficiency, mortality rates, disease levels, reproductive performance) — are easy to identify. Although there are sophisticated methods for estimating risk, it is not so easy to establish the probabilities of receiving a specific price or the likelihood of a disease outbreak, he says.

“The age-old, farmer-proven method of underestimating receipts and overestimating expenses — at least 5% for each — is referred to as risk-based budgeting, and is a useable and useful mechanism for accounting risk,” he continues.

The exercise of estimating building value under different receipt and expense scenarios provides the potential buyer with information that will help answer the question: “What happens if something goes wrong?”

The downside scenarios are the ones to be avoided, he observes. Upside surprises, like higher hog prices or lower expenses, usually don't cause problems.

#2 Receipts

Generally speaking, receipts are a function of price. However, the potential owner's/manager's ability to produce large numbers of hogs efficiently will have a dramatic effect on the quantity of product for sale.

“The only production numbers that are relevant are those estimated by the buyer, as demonstrated by his/her experience and records,” Lines states. “There is an opportunity and a temptation to adjust the production numbers up if the facilities being considered can really be expected to improve animal performance because they allow the use of a more efficient production system, or they permit the same management system to result in better animal performance.

“On-farm experience, however, suggests that buyers need to be extra cautious about projecting and including improved animal performance into the value of the facilities,” Lines continues. “The manager (new owner) is the critical variable here, not the building, and it begins to explain why fair market value of the facilities is different for each producer.”

Naturally, the expected breeding herd and pig performance must be factored in to determine the value of a facility. “It is important, though, not to bid the results of better-than-average management into the value of the facility. The new owner should reap the rewards of excellent management, not the current owner,” he says.

Therefore, when you are estimating the value of a facility, use average animal performance. “Giving away the extra value created by better-than-average management doesn't make sense, even to the casual economist,” Lines notes.

The Ohio economist uses Table 1 to reinforce management impact of production levels and animal performance on receipts. Using hogs sold/sow/year, Lines points out that the difference in sales between an “excellent” manager and a “poor” manager working in the same facility is $800/sow. These figures represent gross receipts, and the costs incurred in achieving these production levels must be considered.

In this example, with a fixed sow herd, Lines added $60 in production expenses (feed, animal health, marketing, etc.) to each hog sold, realizing that costs are also a function of management.

“The extra hogs sold/sow/year under the excellent performance scenario (vs. average) would generate $400 in receipts, added costs of $240 and a net receipt of $160,” he states. “Again, the important message here is: Don't bid your better-than-average management/animal performance (the $160) into the value of the facilities.”

The next big question: What price should you use when estimating annual receipts? Remember, the price plugged into the projections must cover the period of use for the facilities — three, five, seven years or whatever.

“It is important not to get caught in the excitement of a high market or the negative thinking of a low market,” Lines says. “Neither will result in a fair value for facilities.”

His best advice: Use an average price from the current hog price cycle. “The most recent five-year average is as good as any, so long as there are no unusual market situations reflected in the prices,” he says. “We tend to remember the ‘highs’ and ‘lows,’ and we would like to think the highs should represent the future, (but) the averages are more valuable for planning purposes.”

Some managers, of course, are more adept at marketing than others. But again, he advises, “Don't bid your management returns away in what you are willing to pay for facilities.”

Using U.S. prices between 1999 and 2003 (Table 2), the five-year average of $38.11 lands near the midpoint of the highs and lows. Lines says a common swine enterprise budgeting mistake is over-estimating prices. The tendency is to plug in “what the price ought to be.”

Table 3 shows the effect of projected market hog prices on net receipts. “The difference ($375) in hog sales/ sow/ year between the high price ($45) and the low price ($35) scenarios is mostly the market, something the individual producer has little if anything to do with,” he notes. When you have the option of estimating market price in establishing the value of facilities, avoid overestimating that price because it will lead to paying too much for facilities.

Applying a 300-sow, farrow-to-finish operation to the data in Table 3, Lines says overestimating price per hundredweight by $5, for example, can result in annual cash receipts at $56,250 less than expected — regardless of the production efficiency.

Likewise, don't bid your marketing ability into the facility value even though you might be able to capture an additional $3 in a market averaging $40/cwt. “The extra $3 is not return to facilities; it is return to your better-than-average marketing ability,” he reminds.

In the 300-sow example, the extra $3 is worth $34,000 annually. And, if you could market 19 pigs/sow/year instead of the 15 in the example, the reward to management increases to about $43,000 annually.

You can factor in sales of cull sows, boars, etc., but they don't account for a large percentage of receipts — usually 5%. Lines says the price/cwt. relationship with market hogs has averaged about 75% for sows, 80% for non-breeders and 35% for boars.

#3 Costs

Identifying, differentiating and calculating fixed and variable costs are the next challenge. In some financial circles, they are referred to as “cash” and “non-cash,” or “direct” and “non-direct” costs.

This portion of the discussion requires a different approach, he says, primarily because of an economic principal that states: Before the facilities are purchased, all costs are variable.

“There is no question that the owner of facilities has fixed and variable costs, but remember, the ‘fixity’ of some costs only occurs when the facility is owned,” Lines continues. “The fixed costs of the current owner are immaterial to the prospective buyer. It is only after the facilities are purchased that the usual division of costs into fixed and variable comes into play for recordkeeping, tax purposes and some management decisions.”

The largest production cost in any swine enterprise is feed, representing about 35% of the total cost of production in a farrow-to-finish facility. Viewed another way, feed represents 65% of non-facility related costs and 80% of the traditional variable cost of production (not including labor, management and facilities).

The two big variables in feed cost are price, which the owner has limited control over, and feed efficiency, which the owner has greater control over.

Using a five-year average price for primary feed ingredients — corn, soybean meal and supplements — provides a reasonable basis for estimating feed prices. Looking back, Lines says, the five-year average may be less dependable in predicting future feed prices than in predicting hog prices (Table 4). He says some adjustment must be made in feed prices, based on near-future supply and demand.

Equally important, feed efficiency can have a sizeable impact on cost of production (Table 5). With above-average feed efficiency, such as 3.4 lb. feed/lb. gain compared to an average of 3.7, the cost of production differs by 1.6¢/lb.

“This may not seem like much, but it is significant when applied to the large numbers associated with a modern, farrow-to-finish enterprise,” he says, noting an average 300-sow operation would likely produce one million pounds of pork annually. Simple multiplication shows the producer with above-average feed efficiency will spend $16,000 less on feed than the average producer.

“Reduced costs are as good as increased receipts when it comes to the bottom line,” Lines reminds.

Labor is another big, single cost. Lines allocates 16 hours/sow/year as an average for farrow-to-finish operations. “If the total cost of labor (wages, taxes, benefits, etc.) is $10/hour, the cost/sow/year is $160.

Returning to the 300-sow example, the farrow-to-finish operator will use 4,800 hours of labor per year — a tab of $48,000 for two employees.

Again, better-than-average management can reduce these costs.

And be sure to factor in a management fee, whether provided by hired personnel or contributed by the owner-operator. Establishing the proper fee for management services is not so easy, however, unless the actual hired cost is known. This must be included in all costs (except buildings).

“The difficulty arises when management and labor are combined in one or more persons,” he says. “The commercial world of farm managers suggests that management can be hired for about 5% of the gross receipts, with some firms charging as much as 6-7% for livestock operations.

“Two things are more important than the actual percentage,” he continues. “First, be sure to include a charge for management, and second, don't double charge if the labor cost includes a management fee.” In the end, Lines suggests using the 5% figure.

Naturally, there are other non-facility costs, which individually may not seem like much, but when combined may account for up to 25% of the feed tab. For example, be sure to include expenses such as veterinary and medicine costs, boar or semen purchases, livestock insurance, marketing fees, power and fuel, miscellaneous expenses, and interest on operating costs and the breeding herd.

“Farm records and experience are the best sources of information to estimate these costs,” Lines says, referring to a worksheet (Figure 1) that includes a cost for replacement gilts as part of the budget, so there is no sow replacement or sow depreciation cost item in the budget.

Finally, the last group of costs before the use value of facilities can be established is “facility-related costs,” and they do not include the facilities themselves. Lines refers to these costs as the DIRTI 5, except for the big costs — depreciation (D) and interest (I) charge for using capital.

“Depreciation is simply the tax mechanism for recovering the capital cost of facilities,” Lines explains. “In this analysis, that is what we are attempting to estimate — the fair, use-value or capital cost of the facilities. Interest on the capital invested (fair value) will be accounted for in the capitalization process used to convert annual net earnings into a capital (fair) value. The remaining facility-related costs include repairs (R), taxes (T) and insurance (I).

“Taxes and insurance are directly related to the price paid for the facilities — the value we are attempting to estimate,” Lines continues. These costs can be estimated by either making a reasonable “guesstimate” of the property's value, then calculating the insurance and taxes, or by contacting a local real estate assessor and insurance agent for an estimate.

In Lines' example, he assumes an annual charge for taxes and insurance equal to 1% of new cost. Then, the repair costs must be broken into two parts — up-front remodeling/reconditioning costs to make the facilities functional, and the ongoing repairs and maintenance, which Lines says is about 2% of the estimated new or replacement cost of the facility. “The remaining up-front costs will be subtracted from the capitalized value of the net receipts,” he says.

#4 Capitalization

Producers use this value as a measure of how long it will take to recover their investment — the payback period. Financial experts use capitalization to convert expected average annual net revenue into a capital value that estimates the facility's worth.

The fair market value is only as accurate as the ability to estimate receipts and costs accurately. It also reflects the rate of return anticipated for an investment.

Lines says this equation is easy to use:

Capital Value (fair market value) = Annual Net Revenues divided by Capitalization Rate.

The annual net revenues represent the income generated by the facility and do not include the price of the facility in the estimated cost of using it.

Lines says the fact that revenues are not the same every year does not invalidate the capitalization method, but it is less accurate than “net present value” or “return on investment” methods sometimes used.

“The use of average numbers over the life of an asset, as we have suggested doing, allows the use of the capitalization methodology to estimate a reasonable value,” he says. The capitalization rate used should reflect the buyer's capital recovery rate and the desired rate of interest earned on the capital invested in the facility, he adds.

The capital recovery rate is similar to the concept of depreciation — the period of time before the asset is used up (zero salvage value). The interest rate reflects the cost of using money for the investment. “Adding these two important rates together results in the capitalization rate, which when used correctly, will generate a facility value (price) and cost of capital (interest) that can be recovered by purchasing and using the facility,” he explains.

“If the asset is to be used up in one year, the business must recover the full cost in one year and the annual capital recovery rate would be 100%,” Lines continues. If the facility is to be used up in two years, the annual capital recovery rate would be 50%; in five years, the annual capital recovery rate is 20%.

“As a minimum, the cost of using the capital should reflect the local cost of borrowing money to buy the facility — say 6%,” he suggests. “Since the initial amount of investment will gradually be recouped over the life of the investment, only the average capital invested (or half value since there is zero salvage value) is used.

In Lines' analysis, using half the desired annual rate of interest — in this case, 3% — makes this adjustment.

The formula, Capitalization Rate = Capital Recovery Rate + Cost of Using Capital, was used to create the values in Table 6.

Bottom Line

Each prospective buyer will have a different set of costs and receipts and, therefore, a different value for the facilities. Remember:

• Cost and receipts used should represent average management.

• Prices for products and inputs should be average prices for the past five years; input prices may be adjusted to reflect expected market shifts.

• Do not “bid” better-than-average management ability into the value of the facility.

The value of the farrow-to-finish facility in Figure 1 is $483/sow with a five-year capital recovery, and a 6% annual cost of using capital is used to capitalize the annual net return of $111/sow. This only applies if there are no up-front, fix-up costs.

If needed repairs averaged $50/sow, the estimated value is reduced to $433/sow. Multiply this number times the number of sows, say 300, and the estimated value of the facility would be $129,999. Increasing the capital recovery period to seven years would increase the value of the facilities to $177,600.

“The buyer's judgment with respect to useful life or capital recovery period is critical to the value of the facility,” Lines adds.

Bidders can use the worksheet to determine the value of the facility using average management and/or better-than-average management. The former can be used to estimate the price your competitor might be willing to pay, while the latter can help set the top breakeven price, and serve as a guide in outbidding the competition without giving away all of your management returns, Lines concludes.

Figure 1. Worksheet to Estimate Fair Value of Swine Facilities