Financial analysis depends on two basic concepts from utility theory. One, we prefer more money rather than less. Two, we prefer dollars today rather than dollars tomorrow. Not only do these principles hold for everyone from kindergarteners to investment bankers, they help explain all basic financial criteria related to investing. Let’s consider each of these concepts in turn.
First, utility helps explain our behavior in terms of how we attempt to increase or decrease our “relative” satisfaction. Utility theory is used for everything from predicting the success of pornography and Amazon Prime on the Internet to how much sugar people put in their coffee. Utility theory tells us that, from an economic standpoint, size matters; bigger is better; give us Park Avenue over Skid Row. Supersize me.
Second, utility theory speaks to our preference for consuming goods now rather than waiting till later. This gets to the time value of money (and the famous “marshmallow test”). A dollar today is worth more than a dollar in the future; if you have it now you have choices and can do something with it immediately. We prefer consuming to saving. A bird in the hand is better than two in the neighbor’s yard.
How do these concepts apply to forest finance? They encourage us to maximize net present value (bigger is better) and invest in forest management that shortens rotations (time value of money). They remind us to always consider the opportunity cost of putting capital into forests versus our next best investment alternative. These guiding principles and assumptions provide the bedrock foundation for our use of discounted cash flow (DCF) models and related investment criteria.
Click here to learn about and register for “Applied Forest Finance” on March 30th in Atlanta, Georgia. The course details necessary skills and common errors associated with the financial analysis of timberland investments and forest management decisions.