Brent Sheather: Farm values divorced from reality

People buying dairy farms at today's prices face a bleak future unless returns for agricultural produce improve markedly. Photo / Sarah Ivey

Around the world financial markets and their participants are being roundly criticised for everything from over-valuation to over-remuneration.

Bond markets went crazy in 2008 with 30-year US government yields falling from 4.80 per cent in June to 2.55 per cent in December, generating returns of 49 per cent in the process. The US stockmarket is up by 60.1 per cent since its low point in March 2009.

The so-called "great moderation" is well and truly behind us and many experts have an uncomfortable feeling in the back of their minds that maybe "free markets" aren't up to the job.

Unfortunately irrational exuberance is not confined to overseas markets.

Locally we may have our own bubble - a look at the sky-high valuations of rural land in terms of its earning capacity suggests that this market, too, may have taken leave of its senses.

First let's brush up on the basics. Any investment asset like a farm, building or an aluminium smelter is simply worth the cash flow it will produce for the rest of its life appropriately discounted back to its present-day dollars.

No cash flow equals no value, the more risky the cash flow the less it is worth and the sooner you get the money the better. By looking at the price of an asset divided by the cash flow it produced in the past 12 months we can get a rough idea of how cheap or expensive different types of investment are to each other.

This is not the full story because the extent to which a company will build its profits in the future and how volatile these profits are are also powerful influences on its worth.

But, it must be said, getting the growth/risk bit wrong (overstating the former and understating the latter, usually) has been the source of more investment disasters than just about anything else.

Anyway back to the story - some examples of cash flow, prices, and price to cash flow ratios for various assets are listed in the table.

So can any alert reader spot the outlying number in the price/cash flow per share column? Yes, the dairy farm, if the limited partnership being marketed to investors is an indication of the aggregate economics of dairying, looks to be very expensive at 28.2 times cash flow.

Even with the rapid growth in forecast earnings for 2014 the price to cash flow is still 10 times, well above Fletcher Building and BHP Billiton's current price to cash flow ratio.

One or more of three things needs to happen to make buying a dairy farm look rational: either the exchange rate needs to fall, the milk price needs to rise, or productivity needs to improve dramatically.

None of these developments look certain. More importantly, owning BHP and Fletcher Building doesn't involve early starts each morning.

The dismal current economics of dairy farming obviously also concerns the National Bank as in its latest rural economics report it reflects on the over-valuation of farm prices.

In the September report National Bank economist Kevin Wilson comments that activity in the rural land market has stalled and there is anecdotal evidence land values have declined sharply in 2009.

Wilson's excellent analysis notes that over the past 10 years or so farm profits have not kept pace with farm prices; that is, farms have become more expensive.

Data from Quotable Value shows that since 1978 the average price of dairy farms sold per kilogram of milk solids has increased from $5 to an average of $50.80 in calendar 2008. On a per hectare basis the increase is from $2074 in 1978 to $35,000 in 2008.

Despite becoming more expensive, dairy farms don't appear to have outperformed the local stockmarket.

The capital value indices of New Zealand stock market prices and dairy farm prices per hectare have, with the exception of the 1987 bull market, tracked each other closely, so that the index values between 1978 and September 2009 start and end at virtually the same point.

It is important to note that these are capital indices and thus exclude income. Anecdotal evidence would suggest that this handicaps the performance of the stockmarket, with a 6 per cent yield, more than it does dairy farms which in recent years, anyway, haven't produced much in the way of income.

While the performance of capital values is similar, valuations differ markedly. Wilson calculates various valuation measures for dairy farms. For example, he estimates that in December 2008 total dairy farm assets (land, stock, plant and dairy company shares) averaged about $50,000 per hectare as a going concern.

His report then states that the average earnings before interest and tax (ebit), but after the wages of management, in the three years ended calendar 2008, was $1200 per hectare.

In other words dairy farms, in December 2008, were trading at an ebit multiple of 42 times. This number is three to four times comparable multiples for stockmarket listed businesses.

Another way to consider this valuation is to look at what the earnings before interest and tax are as a percentage of the cost to buy the farm; that is, $1200 divided by $50,000, which is equal to 2.4 per cent.

To put this number in perspective, last month the ASB said that its average floating interest rate to farmers was 7.6 per cent.

The significance of these numbers is that the greater the difference between the cost of debt and the return on the assets, the less debt the venture is able to support.

Hence we have seen situations develop like that which befell Crafer Farms, which owned 22 dairy farms around the Central North Island and recently went into receivership.

Wilson's report used dairy farm values as at December 2008.

Since then limited sales evidence from the Real Estate Institute suggests that prices have fallen sharply, and with them, of course, multiples.

But the farm partnership being promoted to investors is valued (with Fonterra shares and cows) at $48,000 a hectare, a little below Wilson's December 2008 valuation of $50,000 a hectare. Still very expensive relative to the other investment assets.

So all in all it's a bleak outlook for future returns from dairying for people buying at current prices.

A contrary view, which might perhaps be held by a believer in the now discredited efficient market hypothesis (this says that share prices accurately reflect reality), might point to the high farm prices as an indication of an imminent fall in the Kiwi dollar, a sharp rise in milk prices or an increase in productivity.

The same circular argument was made about technology stocks in 1999.

More likely the high prices of dairy farms represents a lack of trust in alternatives, a focus on high historic returns, the fact that some long established dairy farmers have no debt and can thus sustain a low return on assets and the impact of the banks, which seem to be doing their best to accommodate their clients and avoid pushing prices down further.

Nevertheless, the National Bank analysis concludes that the longer-term outlook is for lower farm prices across the board. Valuations arguably need to come into line with other competing investment alternatives. It's hard to disagree.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.