The valuation of quarries and landfill sites

ROBIN HOCKING is a qualified valuer and a director of CJ Ham and Murray in Melbourne. He has considerable experience in the valuation of quarries and landfills in Australia, and believes using dual capitalisation rates to value a quarry or landfill site is the most effective method. Although his examples are generally from Victoria, the basic principles of valuation are pertinent to New Zealand.

The valuation of a quarry site is usually made up of the value of the land and reserves to the quarry owner/operator, or the value of a royalty income stream to the lessor/land owner. The latter will not include the value of the quarry business. All sites must be treated as individual and different – even adjoining sites.

The method of valuation is primarily the capitalisation of earnings before interest and tax (EBIT), based on all factors affecting the quarry operation. I stress, all variables used in the capitalisation process are inter-dependent and must not be changed in isolation.

The timeframe over which projected budgets and cashflows are estimated applies equally to freehold or leasehold interest, and the capitalisation of an EBIT should reflect the life of the quarry – up to 25 years – after taking into consideration the geological estimates of the resources, the usable reserves, and the risk in meeting the budget forecasts over the term used.

Valuing reserves

A competent geological report, required in most circumstances, not only provides the  valuer with the volume of the reserves, but also the expected volumes suitable for extraction and sale, together with estimates of overburden etc. It’s important to a valuer, particularly where assessments are being provided to a mortgagee, that the estimates of the resource have been carried out by competent persons whose work will be recognised within the industry.

The volume of ‘usable’ reserves for valuation purposes can be achieved by multiplying the budgeted annual sales by the expected life. The expected life may be the result of dividing the available reserves by the projected output – whichever is the lesser. I have seen several examples of quarry valuations where a unit value per tonne in situ was applied with insufficient consideration given to the marketplace. For example, a unit value of 30c per tonne in situ may be justified if applied to a resource of, say, 2,600,000 tonnes (ie 20 years of life at 130,000 tonnes per annum). However, if that resource is measured at 30,000,000 tonnes, the unit value of 30c per tonne in situ ($9,000,000) is blown out of proportion, with a result as dangerous as fly rock.

Valuation methodology

In my opinion the valuation of a quarry site is best carried out by the capitalisation of a budgeted EBIT. It is unlikely that a valuer will find the sale of two genuine comparable quarries that can be relied upon for comparison by the use of a rate per tonne.  Therefore, I believe it is important to base the valuation on the capitalisation of earnings before interest and tax. This also allows a good comparison between other quarries where all relevant information is available. The financial figures for an operating quarry must be obtained prior to valuation and these figures, at the very least, should provide a fair and reasonable indication of the existing market conditions.

With the capitalisation method, the complications of the valuation are reduced to two major estimates: The sustainable recurring earnings before interest and tax, and the anticipated or acceptable life of the quarry reserves. These two estimates reduce the problems of assessment to a very general and simple question – how much money can the quarry make and how long will it last?

Assumptions and estimates

To complete the valuation it is necessary to make assumptions and provide estimates and budgets on: the total volume of reserves; life of the reserves; annual sales volumes; average selling price; cost of production; EBIT.

The value of the reserves is arrived at by the use of the Present Value formula for projected earnings over a terminal period. This is, in fact, a ‘dual rate’, and in my opinion the sinking fund component should be amended to reflect the risks in replacing capital at an acceptable rate, with further provision for an allowance for income tax paid on the interest earned by the sinking fund.

The life of a quarry can be acceptable up to a period of 25 years and seldom is it necessary to extend that. Periods longer than 25 years have only a marginal affect on the final value.

Plant and machinery

The value of plant and machinery is added to the value of the land and reserves. If the fixed plant is valued at $8,000,000 and the mobile plant at $1,800,000, the total value for the quarry as a going concern is $26,300,000, being a return in perpetuity to the quarry operator of 14.14 percent per annum. The cost of production must include an allowance for depreciation, of plant, the value of which can be added to the reserves to attain the total value of the quarry operation.

Care needs to be taken that the value of the plant does not over-capitalise the operations and produce an unacceptably low return.

Royalties

In my opinion the best royalty agreements are those based on a percentage of the ex-bin selling price. These rates range between three percent and up to 20 percent of the ex-bin, but it is my experience that current agreements fall generally within a range of seven percent and 12 percent.

I believe a royalty income can be capitalized in a similar manner as I suggest with an EBIT. The lessor’s interest requires assumptions on the projected rates of extraction and the risks involved over time for the royalty stream to remain stable, or to increase or decrease. If the lessor’s interest is offered for sale, I suggest the minimum royalty will become an important figure in the mind of a purchaser/investor. Unless the purchaser is familiar with the quarrying industry, a vendor may find it difficult to convince purchasers of the expectation of a higher royalty income stream, and that will be reflected in the capitalisation rates.

There are many instances where the capitalisation of a royalty should reflect a risk free sinking fund for the replacement of capital, similar to the valuation of reserves as a depreciating asset. Capitalisation rates for royalties are likely to fall within a range between 10 percent and up to 17 percent per annum. 

Common errors

There have been many mistakes made by valuers and accountants in the valuation of extractive sites and generally it is only financial difficulties resulting in a sale that allows the valuation to be tested in the marketplace.

Errors include:
• The valuation of the whole of the known reserves when this volume is excessive.
• Use of a low capitalisation rate and with no attempt to use a dual rate reflecting a risk free replacement of a depreciating asset.
• The overestimation of the life of the quarry – consideration for a shorter capitalisation period should be given to isolated quarries that have only a small market share and a low selling price, and also be subject to severe local competition.
• The use of a profit figure or EBIT higher than market indicators – this requires careful consideration and a proper allowance for depreciation of plant and machinery.
• The lack of a proper allowance for future reclamation.

The expiration date of leases and agreements are of vital importance, particularly where there may be the opportunity for a lessor to refuse an extension of a lease.

The difference between the value of freehold and leasehold reserves is often only minor, provided there is security of tenure. It may be incorrect to severely reduce the value of reserves held under lease as compared with freehold reserves, although the security for mortgage purposes will be viewed differently by a financing party.

The value of the hole for a future landfill can be important, but extreme caution must be exercised when projecting a future value for such a use. High risk rates for discounting purposes should be used. Personally, I am reluctant to provide a value for a future landfill unless the closing of the quarry is imminent, and there is a good basis for assuming the necessary permits and consents for landfill will be issued.

It is not uncommon for owners to incorrectly assume the value of the quarry is related to, or even equal to, the value of the gross income, ie reserves of 1,000,000 tonnes and a selling price of $10.00 per tonne equals $10,000,000. This is obviously incorrect, but I have seen valuation reports prepared by consulting engineers stating the value of a quarry based on this assumption. A similar error is made when a profit figure is used over the total volume of reserves without discounting to a present value.      

• This article is a precise from a recent paper by Robin Hocking and does not address all the information and details required for a professional assessment of the value of a quarrying operation.