A lack of knowledge regarding the worth of a royalty interest could be very costly. This can manifest itself in a number of ways. A shrewd buyer may offer a bid far below the interest’s fair market value; opportunities for successful liquidity may be missed; or estate planning could be incorrectly implemented based on misunderstandings about value. Understanding how royalty interests are properly appraised will ensure that you maximize the value of your royalty, whenever and however you decide to transfer it.

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Without offering a full dissertation on valuation, you need to understand that there are three commonly accepted approaches to determining value: asset-based, market, and income. Approaches refer to the basis upon which value is measured.

In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration. However, due to fundamental structural differences between businesses and assets, when valuing royalty interests the available valuation methodologies tend to be utilized differently.¹

The Asset-Based Approach

This approach is not typically employed to determine the value of a royalty interest itself

The asset-based approach can be applied in different ways, but the general idea is that the enterprise value of a business is given by subtracting the market value of liabilities from the market value of assets. While the asset-based approach can be useful when valuing companies operating within the oil and gas industry, this approach is not typically employed to determine the value of a royalty interest itself.  The asset-based approach can be used as a basis for estimating net asset values of an entity that holds royalty or mineral assets, however. Oftentimes, a royalty owner purchased land which included the mineral rights and an allocation of surface versus mineral rights was not performed. Additionally, considerable time may have passed between the time the surface and mineral rights were purchased and the valuation date. Adding to the ambiguity of the cost basis of the asset, royalty interests are often family assets that are handed down for generations. For this reason, the asset approach is typically not used to directly determine the market value of royalty interest assets unless the mineral rights were purchased recently.  It is most often used to help determine entity and equity values of royalty and mineral asset holding entities.

The Market Approach

The market approach utilizes transaction pricing from guideline transaction data or valuation multiples from a group of publicly held companies to determine the value of a privately held enterprise or asset. To develop an indication of royalty interest value using the market approach, you can utilize data from market transactions of mineral interests in similar plays. This data can be derived from direct transactions of royalty interests or from publicly traded royalty trusts and partnerships.

Direct comparable transactions of royalty interests are often the best indication of fair market value. However, the data … is often unavailable

Direct comparable transactions of royalty interests are often the best indication of fair market value. However, the data with which to benchmark a subject royalty interest against is often unavailable. If it is available, a careful comparative analysis must be made. Royalty aggregators (such as Sitio or Kimbell for example), royalty trusts and partnerships hold various royalty interests in wells operated by large exploration and production companies.  Royalty aggregators, trusts and partnerships tend to have very low, if any, operating expenses and can be an investment to provide exposure to oil and gas prices. Acquisition data from these types of entities can be utilized to calculate valuation multiples on the subject royalty’s performance measure(s). This will often provide a meaningful indication of value as it takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach.

Metrics such as EBITDA, distribution yield, and production multiples are commonly considered in this space.  In addition, value is also considered for potential future revenue streams from new wells not yet drilled, to the extent it is not captured in the analysis already.

In many ways, this approach goes straight to the heart of value: mineral rights are worth what someone is willing to pay for them. However, the market-based approach is not a perfect method by any means, for businesses or for mineral rights. Transaction data may not provide for a direct consideration of specific mineral right characteristics; it is imperative that the value conclusion be adjusted for differences in value level and in well economics, potential future drilling locations, among other factors. In any valuation, the more comparable the transactions are, the more meaningful the indication of value will be.

The Income Approach

This approach is the most commonly used approach for royalty interest valuations

The income approach can be applied in several different ways. Generally, such an approach is applied through the development of an ongoing earnings or cash flow figure and the application of a multiple to those earnings based on market returns. For royalty interests, however, we oftentimes perform a discounted cash flow analysis. This approach allows for the consideration of characteristics specific to the subject royalty interest, such as its well economics making it the most commonly used approach for royalty interest valuations.

To perform a royalty’s DCF analysis, production levels must be projected over the well’s useful life or planned or even potential future wells. Given that well production typically decreases at a decreasing rate, these projections can be calculated through considering and/or deriving a decline rate from historical production. Revenue is a function of both production and price; as such, after developing a legitimate prediction of production volumes, analysts must predict future price values. The stream of income (revenue less expenses, taxes and deductions) is then discounted back to present value using a discount rate that accounts for risk in the industry.  For more mature royalty investments, sometimes a capitalization of cash flow can be appropriate as well, depending on the situation.

Because revenue cash flows are the main driver of mineral royalty values, the income approach is, many times, the most reasonable and supportable valuation approach when determining the value of a mineral royalty interest.

Synthesis of Valuation Approaches

A proper valuation of a mineral royalty interest will factor, to varying degrees, the indications of value developed utilizing the market-based and income-based approaches outlined above. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of the mineral royalty and its unique characteristics that provide relevance and credibility to these calculations. This is why industry “rules-of-thumb” are dangerous to rely on in any meaningful transaction. Such “rules-of-thumb” fail to consider the specific characteristics of an interest and, as such, often fail to deliver insightful indications of value. A mineral royalty owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the interest.

We encourage you to extend your wealth planning dialogue to include valuation of any mineral interests, because sooner or later, a valuation is likely going to happen. Proactive planning and valuation services can alleviate the potential for a negative surprise that could complicate an already stressful time in your personal life.

For more information or to discuss a valuation or transaction issue in confidence, do not hesitate to contact us.

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¹ Treasury Regulations 1.611-2(d) asserts that the income approach will not be used if the value of a mineral property can be determined using the cost-approach (under the asset approach) or the market approach. However, those circumstances are rare and not consistent with industry norms. The income approach is most often employed to estimate the fair market value of mineral properties.