Better Investment Evaluation using Market Based NPV

May 6, 2013 • Tell FriendsPrinter Friendly

This article will discuss an advance NPV method based on market information. This is a resume of two workshop materials delivered by the recognized experts in energy asset valauation, i.e:

  1. David Laughton, Phd (Adjunct Prof in University of Alberta, Canada)
  2. Michael Samis, Phd (Partner in Ersnt & Young –  Canada)
  3. Prof. Graham Davis, (Prof in Colorodo School of Mine, USA)

They popularize the application of Real Option/Market Based Valuation techniques to improve investment decision making in Mining and Petroleum Industry. This article will used a term of “Market Based NPV” instead of Real Options and Market Based Valuation, just to provide clarity for readers that this new technique is still based on the principles of the traditional NPV with a little adjusting on Risk Discount Factor


We start this article with the question what makes an economically viable project

Fig.1 Conditions for the viable project

The above figure descrbe that the project economics is viable if net profit after tax of the project is still positive when we deduct it with capital + financing cost and the return compensating for the project’s risk.
Talking about the project’s risk, each project has its own uncertainty and risk characteristic and it should be recognized in a project economics.

Currently Discounted Cash Flow (DCF) based NPV was predominantly used due to simple and straight forward. This method would discount future cash flow with a constant discount rate for compensation of the risk of future cash flow. The formula is shown in the below figure.

Fig.2 DCF NPV Formula

Discount rate in DCF NPV accommodate two factors, i.e:

  1. Market Risk Adjusment related to risk on some uncertain variables such as price, production rate, etc.
  2. Time Adjustment related to the inflation (time value of money).

Fig.3 Discounting Mechanism in DCF NPV

As shown in figure 3, the DCF NPV would discount project cash flow using a constant discount rate. This is problematic since it violates the principle of investor risk aversion where net cash flow uncertainty is not increasing at a constant rate (Blais et all, 2006). Using this method, the longer the project would be put into production, the higher the discounting factor would be applied to the cash flow generated from the project. This would penalize long-lived projects in oil and gas industry –> Problem no 1.

DCF versus Market Based NPV

Fig.4 DCF vs. Market based NPV

As shown in figure 4, the first step in Market based NPV is to apply a risk discount factor to each uncertain cash flow element arising over any one period.

The difference between the DCF and Market based NPV methods in risk adjustment appears to be nuanced, but its consequences are potentially large.

The detailed project cash flow dependence on these underlying uncertain variables then determines how these underlying risk adjustments are implicitly transformed into risk discounts for the project cash flow.

Risk discounting the project cash flows in this way grounds the valuation in the financial markets of relevance to investors. It also tunes the risk discounting to the types and amounts of risk actually in the project cash flows in a controllable way, as opposed to using some average discounting that it is not likely to be appropriate for the risk involved.

This process allows management to use financial market information to determine the underlying structure of risk adjustments for uncertain variables of interest to the corporation such as future price from commodity exchange.

The use of Market Information

Although natural resource industry has a high risk in both market and sub-surface matter, this industry has a market that trades commodity price in the future. This is a benefit of practitioners in this industry to use the futures price to justify their investment decision.

Forward Price is the contract price agreed by both parties where one party agrees to deliver the commodity at a specified time in the future. Someone who agrees to enter into this contract will be exposed to commodity price risk (commodity price in the future will be different from the current price)
Basically, investor is risk averse. Risk discount factor is applied to the spot price to compensate for price differentials.
Below figures shows the historical future price and the long term trend in each period

Fig 5. Oil forward prices 1989-1991 showing short-lived spike

Fig 6. Oil forward prices 2002-2005 showing shift to new higher long-term trend

Fig 7. Oil forward prices Sept 12- Mar13 showing shift to new lower long-term trend

Commodity prices exhibit reversion to a long-term equilibrium due to market forces uncertainty growth slows with long term.
In markets with long-term equilibrium forces:

  • price uncertainty increases more slowly in the long term than in the short term
  • constant discounting undervalues long-term cash-flows that increase with such long-term prices


Theory Behind Market Based NPV

There are 4 (four) Valuation Principles underlying Market Based NPV, i.e:

1. Values in any time t are additive

Fig 8. Operating vs Investment Cash Flow stream

Adding the present value of operating and investment cash flow together seems so simple. However, dynamic risk variation in each cash flow stream is not often appreciated.
Commonly, we assumed these cash flow stream have the same risk –> problem no 2. In fact, they have a different risk. Operating cash flow is riskier than investment cash flow

2. There is a time value of money

Investor prefer a cash flow that occurs sooner rather than later. When considering two riskless cash flows of the same magnitude, investor will pay less for the cash flow that occurs later.
In calculating a present value, a time discount factor adjusts for the time value of money. It is dependent on the riskless interest rate and timing. Cash flow risk is a different issue and is considered separately (it would be discussed in the next principle).

3. Investors are compensated for exposure to dynamic risk variation

Supposed, there are two investment products as follows:

Investors tend to prefer less uncertainty to more. They would prefer the second investment due to certain return. Paying anything less than $1.25 million for the first investment reflects the need for a positive expected return for bearing risk.

Risk adjustments to cash flow is Risk Premium (%) or Risk Discount Factor (RDF)

The higher the risk premium, the smaller discount factor. Risk Discount Factor is the amount an investor would pay for an uncertain cash flow that is expected to pay off $1. This is difference with Time Discount Factor that is the compensation an investor receives for the delayed receipt of money.
Risk adjustments is determined only by economy-wide uncertainties

Uncertainty in local geological and technical variables is not correlated with state of economy. This geological and technical risk is not dependent on the economic situation. A common error in project valuation is to increase discount rate to accommodate the geological and technical risk –> problem no 3.

4. Comparable assets must have the same price

The key idea is that two assets with the exactly the same cash flow characteristics must have the same price ( exact substitute)
Unfortunately, exact substitute are rare. Fortunately, portfolios can often be constructed that exactly replicate the cash flows of the asset being valued. The individual elements of these replicating portfolios can be priced in the market.

Example: There is only one bike store in your town. They sell a bicycle for $230 The bicycle is made up of a frame, two wheels, a handlebar, and a seat. There are no comparable bicycles (no exact substitute since there is only one store) in the market. However, a bike mail order catalog shows that:

  • wheels for $ 40 each,
  • frames for $ 100 each
  • handlebars for $ 20
  • seats for $ 30

Replicating Portfolio Price of Bike = 2 x $ 40 + $ 100 + $ 20 + $ 30= $ 230 –> the bike is fairly priced

Simple Case

There is a natural gas project. It is expected in year 5, gas flow will generate $100 million sales with $60 million for operating cost. You should find the present value of a $40 (100-60) million gas field cash flow 5 years out.
The traditional way to value this cash flow is seen below:

What is the value of r based on market?

From the commodity market, we get info are the following:

  • one natural gas forward contract is traded at $0.80 now for $1 received in 5 years. It means that risk adjustment is 0.8 (RDF5 x TDF5 = 0.80).
  • one treasury bond is traded at $0.90 now for each $1 received in 5 years. It means that time adjustment is 0.9 (TDF5 = 0.90).


Based on this market info, we can replicate our investment in the real natural gas project with an investment in commodity market. We could sell 100 contracts of our yr 5 natural gas now and buy 60 contracts of 5 yr T-bond to pay off the yr 5 operating cost.
The present value of net cash flow in year 5 is:

$100 mio x 0.80 + (-$60 mio x 0.90) = $ 26 mio

The cash flow cannot be valued at less than $ 26 million, because no owner would sell them for less when they can sell the gas production today and buy bonds to lock in future cost for a net gain of $ 26 million.
The cash flow cannot be valued at more than $ 26 million, because those who want year 5 gas field gas can obtain it for $ 26 million via the replicating portfolio (buy the forward gas from an operator and at the same time put a bond up to secure costs)
This is the “law of one price” at work, which holds as long as there is a replicating portfolio that can be constructed at low transaction cost.

At present value of $0.26 million, the market is telling us that the expected net cash flow of $0.40 million in 5 years time needs to be discounted at precisely r = 9% per year in the standard DCF method, so the result is:

To find Risk Discount Factor (RDF) from total discount of 0.65, we can break down it usng this formula PV CF5 = Net CF5 x TDF5 x RDF5

The net cash flow Time Discount Factor (TDF5) is 0.90 (~2%/yr), so the Risk Discount Factor (RDF5) must be 0.72 (~7%/yr), so that

TDF5 x RDF5 = 0.90 x 0.72 = 0.65


– The primary valuation challenge is to recognize :

  • the uncertainty during the project life
  • the impact on the cash flow uncertainty characteristics

– Market Based NPV recognize the risk uniqueness of each project

– DCF analysis discounts all cash flow streams at the same rate. Market Based NPV brings this out and apply :

  • higher discounting for riskier cash flow stream
  • lower discounting for less risky cash flow stream

– Market Based NPV is more proper to value oil and gas projects rather than DCF

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