Abstract
This paper will briefly discuss the derivation of market value discount rates from market sales and, separately, from cost-of-capital approaches. The paper will then focus on the reasons for the apparent disparity whereby discount rates derived from market sales consistently exceed, on an annual average basis, discount rates calculated from cost-of-capital. Studies done over the period from 1985 through 2000 suggest that market value discount rates derived from actual market sales average 22-25% Before Federal Income Tax (BFIT) while discount rates calculated using cost-of-capital methods for public oil and gas companies average 14-18% BFIT. These source-based differences in discount rates have been noted by authors and, more frequently, by users of the data and are a significant source of controversy for those who rely on such data for the specification of valuation parameters. Four primary sources for the difference(s) which have been suggested are examined and discussed in the paper and in underlying, referenced research. These sources are: (a) Specific Property Risk as compared to Portfolio Risk; (b) Return-of-Investment not included in Cost-of-Capital; (c) Reserve Risk in addition to Specific Property Risk; and (d) the difference in Liquidity of investments made in stocks and bonds as compared oil producing properties. The paper and the underlying work draw on previously published studies from the petroleum evaluation and financial communities along with ongoing market sales data studies to examine each area of difference in detail and attempt to quantify the effect of each on the market value discount rate.
