Understanding and Determining Net Asset Value (Part 1)
Net Asset Value (“NAV”) is an important financial metric utilized in the energy industry which quantifies the current value of an asset. This article dives into how NAV is calculated and why NAV is important to investors.
September 1, 2023
All energy projects, including oil & gas, solar, wind, and battery storage, are developed with the expectation that such projects will yield a desired return on initial investment. The standard method used for calculating NAV is called Discounted Cash Flow (“DCF”). DCF is a methodology which translates dollars that arise in the future into an equivalent number of dollars today ("Present Value") such that a target rate of return is achieved over a target period. In a DCF model, the present value of a future cash flow is a function of the timing of the cash flow, the magnitude of the cash flow, and the discount rate (i.e. the desired rate of return). The general formula for calculating Present Value is the following:
The Discount Rate is also known as the Internal Rate of Return (“IRR”) and is meant to reflect the rate of return that is commensurate with the level of risk undertaken by the project. There are a variety of variables that can drive the discount rate, but the most common are the expected volatility of future cash flows and their timing.
What Makes Energy Investing Unique
Already developed energy projects tend to share certain characteristics that make them unique when compared to many other asset classes.
Unlike other investments such as real estate, energy investments in existing assets typically have a front-loaded cash return profile where the vast majority of cash flow is projected in the first few years of an investment's life cycle. This occurs for several reasons, but the most important is the depleting nature of such projects.
This is very different than most real estate projects where a sponsor will raise funds, acquire a piece of land, initiate construction of a building and begin leasing out the building with the intention to sell the whole project 4-5 years out at a premium (which is where the majority of the return for investors comes from).
Cashflow: Real Estate vs. Proven Energy Assets
Stated another way, most of the return generated by already proven energy assets occurs from ongoing distributions from the underlying assets rather than a future projected sale. This can be highly attractive for many investors given the long lock-up periods that many real estate alternative investments have.
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