Economist Irving Fisher[1], in thinking about the worth of an asset, wrote: “Capital value is income capitalized, and nothing else.” Capitalization refers to the conversion of expected future income into an estimate of present value. This means any valuation effort requires looking forward.

While modern day forecasts rely more on data analysis and spreadsheets than Ouija boards and Magic 8 balls, the results remain similarly ambiguous.

Consider back-testing timber price forecasts applied to annual or multi-year budgets. First, the variance analysis will find that the forecast was wrong. So, one could decide, “hey, we’re not going to use forecasts anymore for wood procurement budgets or forest management.” We could change our approach to capital budgeting at the corporate level. Instead of asking, “given this timber price forecast, where should we invest?” we turn to, “given that we don’t know what timber prices will be, what should we do?”

Even during our global volatility infusion, all kinds of projects come across the shared Zoom screen: reforest with better seedlings, install another CDK (continuous dry kiln), replace the boiler, rebuild the paper machine, buy new skidders….  What’s the decision exercise? Specify criteria. Rank the projects against the criteria. Draw a line somewhere on the ranked list that says, “we would invest in the projects above the line, and those below the line scare us or conflict with our objectives.”

Next, add up the dollars required for the good projects and figure out how to pay for them efficiently, if you can. Revisit the line. Discuss vigorously.[2] This may cause you to move the line up (budget constraint) or move the line down (financing is cheap, hee haw!). When comparing the preferred projects to their budgets, dig in hard to confirm the ability of the organization to get them done well. Just because the numbers look good does not mean the project fits the team. An attractive $1 million project handed to the wrong team produces a $1 million write-off.

Forecasts serve a role here. They can help compare timber or mill projects against a common set of assumptions. Use market data and forecast scenarios to understand and rank markets better.  The question with the forecasting exercise is, “Do we know more about wood baskets or timber markets when finished than when we started?” If so, we improve the quality of our investment decisions.

 

Click here to view the agenda and learn more about our annual “Wood Flows & Cash Flows” conference, held virtually on December 8^th. Topics include the analysis and ranking of timber markets and wood baskets for investment applications.

 

[1] Austrian economist Joseph Schumpeter called Fisher “the greatest economist the United States ever produced.”

[2] Which projects make the final list? Where do you draw the line? When reviewing projects internally or with clients, I’m thinking “How do we prioritize projects? What are the criteria that help us sort and stack? What are the risks? How do we mitigate these risks? Who will get the project done?” At this point in my career, I have learned to think more and hard about the team involved. An okay project with a great team will outperform a great project handed to an unprepared crew.