There are some assumptions that I need to make you aware of when using certain valuation methods, including the Discounted Cash Flow Method, to calculate the value of a solar power installation once ten years have already passed. Explaining and outlining these assumptions may go some way to support my on-the-surface outrageous conclusion that, for many households, the value of a solar power installation may be worth more ten years from now than it is on the date of purchase and installation, even when considering the loss in energy efficiency that occurs over time.
You heard me – even once you have depreciated the solar power installation by 100% (assuming that depreciation is available to you), the system may be worth more at the end of ten years than the date that you paid for it.
This is an outrageous conclusion – so let’s look at how I got there.
Which Valuation Method Do I Use?
There are basically three methods to use to calculate the value of a solar power installation at the end of 10 years:
1) You can wait until you sell the property.
This is arguably the most reliable method of calculating a valuation of anything, because an asset is only ever worth what somebody else is prepared to pay for it in the condition it’s in. It’s not going to give you any idea how much the piece of equipment is worth in advance, however, so for our purposes it is not particularly helpful, and we’ll set it aside.
2) You can go by a professional valuer.
This is a good option for accuracy, but with an asset worth only between $5,000 and $10,000 to begin with, the cost of getting a professional valuation done is likely to be prohibitive (not that it shouldn’t be considered as a case study, though). Furthermore, there is a reasonably high chance that the valuer will actually use the valuation method listed below.
3) You can use the Discounted Cash Flow Method.
The Discounted Cash Flow Method is an established method of valuation for valuing just about any asset that has the potential to generate future cash incomes. It is widely used in investment circles to calculate the present value of company stock prices based on their rate of growth, their level of risk, and the relative weight of other opportunities.
Next week, I’ll be using the last of these three methods to calculate the value of a solar power installation at the end of ten years.
Assumptions to Keep in Mind When Using the Discounted Cash Flow Method to Calculate the Value of Solar
The golden rule of the Discounted Cash Flow Method is “garbage in, garbage out”. That is, the poorer the quality and accuracy of the data you put in, the less reliable the resulting valuation.
For this reason, it’s important to go over and carefully unpick the assumptions used in this calculation, as they run the risk of varying greatly from household to household depending on many many factors.
Assumption #1 – The “value of annual consumption saved” is based on your actual household data. This is in turn based on your own home energy use calculations as you have recorded them over time, and may vary a great deal if you haven’t been doing your homework correctly.
I cannot stress this enough. If you haven’t been doing your homework on your own household consumption prior to implementing solar, these numbers are likely to be way off. The value of annual consumption saved has such a huge bearing on the actual value of the solar power system using the Discounted Cash Flow Method that if you stuff it up even slightly it can give you a totally incorrect future value.
Basically, if you’ve done a poor job of doing your homework, it’s going to result in a worthless valuation.
Assumption #2 – The “value of annual consumption saved” will also be affected by the equipment you choose to use. Make sure that you use the right consumption savings assumptions based on the quality of the equipment you are using. Even using data based on the wrong type of micro inverter can mean that your consumption estimate is thrown off by a few extra cents per day. This can have a huge impact on the future value of your solar installation using the Discounted Cash Flow Method.
Assumption #3 – Retail energy prices go up in time by a certain annual average. This was the most eye-opening detail for me when it came to calculating the future value of a solar power installation using the DCF method. The fact that energy prices are continually going up, generally by a rate well above the rate of inflation in the retail energy sector, completely opened my eyes to the possibility that a solar power installation put in place today may actually be worth more in ten years’ time than it is today, even after you have fully depreciated the asset in line with the IRD depreciation schedule. That is because the gradual upwards march of retail energy prices tends to outweigh other calculations to do with the “discount rate” (in this case I’ve used the NZ government 10 year government bond rate), and even the loss in effectiveness of solar power equipment that tends to kick in over a 10 or 20 year time span.
That being said, the rate at which you calculate the increase in prices has a heavy bearing on the value produced by the DCF method. It makes a sizeable difference whether the rate you use is 3% or 3.5%. In my calculations, I have used the rate of 3.2%, because this was the average increase in retail energy prices over the ten year period 2004 to 2013, which is a time period that although not super current, has the fullest amount of information collected over 10 years. (A more comprehensive reading over 39 years indicates that the rate is between 3% and 3.1% annually.)
It is also important to note that if you live outside of New Zealand, you will need to calculate the increase in retail power prices in your own country. Also note that the actual changes in power prices may vary somewhat from retailer to retailer, as will your own actual increase in prices, depending on the regularity and the accuracy with which you shop around for better retail power prices.
Assumption #4 – The value of the 10 year NZ Government Bond rate is an appropriate “Discount Rate”. This is endlessly debatable – but I follow Warren Buffett in saying that the best “risk-free” discount rate is the rate of a long term government bond of your government. In a financial sense, it is highly unlikely that the NZ government will fail in the next ten years. 10 years also matches the timeframe we are using, and is at a higher interest rate (leading to a more conservative calculation in this instance) than either of the shorter period NZ Government Bond interest rates.
Assumption #5 – There are not really any risks in solar. I know, knock on wood, right? As soon as you say it, something bad tends to happen. But that being said, there aren’t really any foreseeable risks to installing solar panels, apart from a major storm causing damage to your property and/or requiring unexpected maintenance – in which case you would probably be covered by insurance anyway. If I am correct, however, the rate of return can be close to that of a high-yielding corporate bond, but without any of the risk associated with such an investment.
Assumption #6 – The lifespan of a solar system is approximately 25 years. The lifespan of solar panels makes a fairly significant difference to the end-of-ten-year valuation of the equipment. While additional years are diminished through the discounted cash flow method, they would still add some marginal value to the valuation. I fully expect my solar power system to last for 30 years – but if the system lasts more than 25 years, from a valuation perspective, it will be considered a bonus.
Now that we’ve got the assumptions out of the way, we can get to the fun part, which is actually calculating the value of a solar power installation even once ten years have passed.
