What is the proper formula to value a company whose main business is
supplying or harveseting commodities (ex. oil, minerals, lumber) and
what should the expected return of that firm/company be over time?

There are two main approaches to valuing commodity producers.  The
first is based on normalized cash flows, and the second uses an option
formulation.

This first article, "COMMODITY PRICES: ?THEQUICK AND THE DEAD?
thebigpicture (July 5, 2004)
http://www.thebigpicture.com.au/newsletters/newsletter0507.pdf,
provides an overview of the issues involved in valuing commodity
producers.

The following two articles provide explanations of the two valuation
methods, including at least one detailed example of each:

"VALUING FIRMS WITH NEGATIVE EARNINGS" Chapter 22
http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch22.pdf (pages
15-20)

"THE OPTION TO DELAY AND VALUATION IMPLICATIONS" Chapter 28
http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch28.pdf (pages
21-30)

The following is a spreadsheet that implements the options valuation
approach: "A model that uses option pricing to value a natural
resource company; useful for valuing oil or mining companies."

"CORPORATE FINANCE: Theory and Practice" by ASWATH DAMODARAN (1997)
http://www.stern.nyu.edu/~adamodar/pc/natres.xls

A video of a lecture covering options valuation of natural resource
companies can be found here:  "23 (4/20/05)"
http://sterntv.stern.nyu.edu:8080/ramgen/faculty/adamodar/b40333120s05/042005-adamodar-b40333120s05.rm.
 The corresponding class notes are located here:  "Part III: Real
Options, Acqusition Valuation and Value Enhancement"
http://www.stern.nyu.edu/%7Eadamodar/pdfiles/eqnotes/packet3a.pdf
(pages 30-61)

An extremely comprehensive website on valuation, from which most of
these materials are drawn, is located at:  "Valuation"
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valuation/val.htm.

Expected rates of return are typically calculated using the dividend
discount model or the capital asset pricing model.  Information on the
dividend discount model is available at:  "Earnings Growth and Stock
Returns" By Truman A. Clark,
Dimensional Fund Advisors Inc. (August 2000)
http://library.dfaus.com/articles/earning_growth_stock/.  Information
about the CAPM is located at:  "Session 9: Capital Asset Pricing Model
(CAPM)" NetTOM http://cbdd.wsu.edu/kewlcontent/cdoutput/TOM505/page42.htm.
 Generally, expected rates of return increase with risk.  Therefore,
the more volatile the commodity that is being produced, typically the
higher the expected rate of return.

Search Terms:  "expected rate of return"; "expected return" "commodity
producer"; "expected return" commodity company; valuing commodity
companies; harvest commodities valuation; value resource company;
value extraction company; equity extraction company; equity natural
resource company; valuing natural resource company; valuation
commodity extraction company

Sincerely,

Wonko

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Request for Answer Clarification by dgcoker-ga on 21 Jul 2005 07:41 PDT

This answer is to general.  I am looking for a simple business model
for a commodity firm like profits= (commodity price x conversion cost
ratio)- selling expense or such.

Thanks

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Clarification of Answer by wonko-ga on 21 Jul 2005 16:04 PDT

Something similar is employed in the spreadsheet I provided as part of
my Answer, which uses the option valuation approach.  It uses the
formula: Estimated reserves of the natural resource * (Current price
of the natural resource, per unit - marginal cost per unit of
extracting the natural resource) to create a virtual share price.  The
spreadsheet as a whole takes a more sophisticated approach by treating
the firm's reserves and extraction opportunities as an option, with a
strike price based on the cost of developing the extraction
opportunity and variability provided by the volatility of the
commodity's price.

I suggest you take a closer look at "CORPORATE FINANCE: Theory and
Practice" by ASWATH DAMODARAN (1997)
http://www.stern.nyu.edu/~adamodar/pc/natres.xls, which is very
specific to natural resource firms and is straightforward to use.  The
other approach is based on discounted cash flows, which is discussed
in the book chapters I provided, and is also tailored to valuing firms
harvesting commodities.

I am concerned that a formula like you have suggested is overly
simplistic because it ignores the volatility of the commodity, which
plays a huge role in how the firm is valued.  As Chapter 22 indicates,
the best way to use a formula like that is to adjust it for the value
of the firm's option to produce more when prices are high and to
produce less when prices are low, which is discussed in Chapter 28.  I
especially suggest looking at Illustration 28.5 (pages 28-29), which
illustrates how to value an oil company.

Sincerely,

Wonko