5 Common Trading Multiples Used In Oil And Gas Valuation

Posted: Dec 21, 2011

Chris Dumont

Contact | Author Bio

ARTICLE HIGHLIGHTS

• A fundamental aspect of investing is to understand the companies and sectors.
• Enterprise multiples can vary depending on the industry.
• One metric should never be used in isolation.

A fundamental aspect of investing is to understand the companies and sectors in which a person invests. With equities, there are a number of sectors, and equity investors require some specialized knowledge to make educated investment decisions. One of those sectors is oil and gas, where analysts, to give a better idea of how these companies fare against the competition, use specific multiples. With a basic understanding of these common multiples in oil and gas, investors can better understand the fundamentals of the oil and gas sector.

The five common multiples we'll look at are 

1. EV/EBITDA, 
2. EV/Production, 
3. EV/2P, 
4. P/CF and 
5. EV/DACF.

Enterprise Value to EBITDA: EV/EBITDA 

-  Also referred to as the enterprise multiple or the earnings before interest, taxes, depreciation and amortization (EBITDA) multiple, this is often used to determine the value of an oil and gas company. 

-  One of the main advantages of the EV/EBITDA ratio over the price-earnings ratio (P/E), the most popular valuation multiple, and the price-to-cash-flow ratio (P/CF), is that it is unaffected by a company's capital structure. 

-  If a company was to use the P/E ratio and issued more shares, it would decrease the earnings per share, thus increasing the P/E ratio and making the company look more expensive, whereas the EV/EBITDA ratio would not change. 

-  At the same time, if a company is highly leveraged, the P/CF ratio would be low, whereas the EV/EBITDA ratio would make the company look average or rich. 

-  The EV/EBITDA ratio compares the oil and gas business, free of debt, to EBITDA. 

(To learn more on investment ratios, see Analyze Investments Quickly With Ratios.)

-  This is an important metric as oil and gas firms typically have a lot of debt and the EV includes the cost of paying it off. 

-  EBITDA measures profits before interest and the non-cash expenses of depreciation and amortization. 

-  In times of low commodity prices multiples expand, and in times of strong commodity prices multiples contract.

Another variation of the EV/EBITDA ratio is the EV/earnings before interest, taxes, depreciation, depletion, amortization and exploration expenses ratio (EBITDAX), which is similar except EBITDAX is EBITDA before exploration costs for successful efforts companies. 

-  It is commonly used in the United States to standardize different accounting treatments for exploration expenses, which consist of the full cost method or the successful efforts method. 

-  Exploration costs are typically found in the financial statements as exploration, abandonment and dry hole costs. 

-  Other noncash expenses that should be added back in are impairments, accretion of asset retirement obligations and deferred taxes.

-  A low ratio indicates that the company might be undervalued. 

-  It is useful for transnational comparisons as it ignores the distorting effects of differing taxes for each country. 

-  It is also often used to find takeover candidates, which is common within the oil and gas sector. 

-  The lower the multiple the better, and in comparing the company to its peers it could be considered undervalued if the multiple is low.

-  Additionally, enterprise multiples can vary depending on the industry. This is why it is important to only compare companies within the same industry. 

(For additional reading, see Relative Valuation Of Stocks Can Be A Trap.)

Enterprise Value/Daily Production: EV/BOE/D

-  Also referred to as price per flowing barrel, this is a key metric used by many oil and gas analysts. -  This takes the enterprise value (market cap + debt – cash) and divides it by barrels of oil equivalent per day (BOE/D). 

-  All oil and gas companies report production in BOE. 

-  If the multiple is high compared to the firm's peers, it is trading at a premium, and if the multiple is low amongst its peers it is trading at a discount.

-  However, as good as this metric is, it does not take into account the potential production from undeveloped fields. 

-  Investors should also determine the cost of developing new fields to get a better idea of an oil company's financial health. 

(To learn more, see Unearth Profits In Oil Exploration And Production.)

Enterprise Value/Proven + Probable Reserves: EV/2P

-  This easily calculated metric, which requires no estimates or assumptions, helps analysts understand how well resources will support the company's operations. 

-  Generally the EV/2P ratio should not be used in isolation, as not all reserves are the same. 

-  However, this multiple can still be an important metric to use to evaluate the valuation of acquiring properties when little is known about the cash flow.

-  Reserves can be proven, probable or possible reserves. Proven reserves are typically known as 1P, with many analysts referring it to P90, having 90% probability of being produced. 

-  Probable reserves are referred to as P50, or having a 50% certainty of being produced. When used in conjunction with one another it is referred to as 2P. 

-  When this multiple is high, the company of interest would be trading at a premium for a given amount of oil in the ground. 

-  A low value would suggest a potentially undervalued firm. EV/3P can also be used, which is proven, probable and possible reserves together. 

-  However, as possible reserves only have a 10% change of being produced it is not as commonly used.

(For related reading, see Oil And Gas Industry Primer.)

Price to Cash Flow: P/CF 

-  Oil and gas analysts will often use the price-to-cash-flow per share multiple. 

-  A few advantages of the price–to-cash-flow multiple is that in contrast to earnings, book value and the P/E ratio, cash flow is harder to manipulate. 

-  Earnings can always be tweaked by aggressive accounting, and book value is calculated using subjective depreciation methods. 

-  One disadvantage is that while easily calculated, it can be a little misleading if there is a case of above average or below average financial leverage.

-  To calculate this, take the price per share of the company that is trading and divide it by the cash flow per share. 

-  In order to limit volatility in the price, a 30-day or 60-day average price can be used to obtain a more stable value that is not influenced by random movements.  

-  The cash flow in this case is the operating cash flow, which takes the operating cash flow less exploration expenses. This method adds back in non-cash expenses, depreciation, amortization, deferred taxes and depletion. 

-  For oil and gas companies in particular, due to their nature, this allows for better comparisons across the sector. 

-  Lastly, the share amount in calculating cash flow per share should be calculated by taking the fully diluted number of shares for most accurate results.

(For more on price to cash flow, read Analyzing The Price-To-Cash-Flow Ratio.)

-  Moreover, it is also important to note that in times of low commodity prices multiples expand, and during high commodity prices multiples decrease.

Enterprise Value/Debt-Adjusted Cash Flow: EV/DACF 

-  The capital structure of oil and gas firms can be dramatically different. Firms with higher levels of debt, or more leverage, will show a better P/CF ratio, which is why the EV/DACF multiple is preferred.

-  This multiple takes the enterprise value and divides it by the sum of cash flow from operating activities and all financial charges that include interest expense, current income taxes and preferred shares. 

Conclusion

These are five of the most common multiples used in oil and gas. There are others, of course, and one metric should never be used in isolation. Because of the advantages and disadvantages of each multiple, more than one metric should be used and investors should not limit themselves. Other tools such as the discounted cash flow method should be used in conjunction for a more accurate gauge on placing a value on an oil and gas firm. 

(To learn more about discounted cash flow, see DCF Analysis.)

by Chris Dumont

Read more: http://www.investopedia.com/articles/basics/11/common-multiples-used-in-oil-and-gas-valuation.asp#ixzz1hbLJnaQg

Analyze Investments Quickly With Ratios

Jonas Elmerraji

Contact | Author Bio

Ratios can be an invaluable tool for making an investment decision.  Using ratios to make informed decisions about an investment makes a lot of sense, once you know how use them.

There are a large variety of ratios out there, but financial ratios can be broken up into four major categories:

1. profitability ratios,
2. liquidity ratios, 
3. solvency ratios and 
4. valuation ratios. 

 (To continue learning the basics to analyzing a company, see our Ratio Analysis, Introduction To Fundamental Analysis and Advanced Financial Statement Analysis tutorials.) 

Profitability Ratios

- Profitability is a key piece of information that should be analyzed when you're considering investing in a company. 

- This is because high revenues alone don't necessarily translate into dividends for investors (or increased stock prices, for that matter) unless a company is able to clear all of its expenses and costs.

-  Profitability ratios are used to give us an idea of how likely it is that a company will turn a profit, as well as how that profit relates to other important information about the company.

One example of an important profitability ratio is the profit margin.

The profit margin is calculated as follows:

In general, the higher a company's profit margin the better but, as with most ratios, it is not enough to look at it in isolation. It is important to compare it to the company's past levels, to the market average and to its competitors.

There are a couple of red flags you should watch out for with the profit margin, especially where the company is seeing decreasing profit margins year over year. This can suggest changing market conditions or where the company is seeing increasing competition or rising costs. Also, if a company's profit margin is out of line compared to the rest of its industry, it is worth the extra effort to find out why.

-  If a company has a really low profit margin, it could mean the company will land in a bad position if market conditions change. 

-  A really high profit margin relative to an industry could mean that the company has arrangements or advantages that might not last.

Other profitability ratios include operating margin and gross margin. (Read more about margins in Zooming in on Net Operating Income, The Bottom Line On Margins and Measuring Company Efficiency.)

Liquidity Ratios

-  Liquidity is a measure of how quickly a company's assets can be converted to cash. 

-  Liquidity ratios can give investors an idea of how capable a company will be at raising cash to purchase additional assets or to repay creditors quickly, either in an emergency situation, or in the course of normal business.

The receivables turnover ratio is a liquidity ratio that measures a company's ability to collect on debts and accounts owed to them.

Receivables turnover is calculated as follows:

-  This ratio represents the number of times in the period that the payments owed to a company will be collected. 

-  If you divide 365 by the receivables turnover ratio, you will find the average number of days that it takes a company to collect on receivables, or the number of days between the time it takes a company to make a credit sale and the time that it receives a cash payment..

-  In the case of this ratio, a higher number means that the company collects more frequently (good liquidity), whereas a low ratio may mean that clients are not paying up in a timely manner. Like most ratios, the true value of the information isn't really there unless you make a comparison across the industry.

Other liquidity ratios include working capital turnover, inventory turnover and current ratio. (To continue reading on liquidity, see Do Your Investments Have Short-Term Health?, Working Capital Works and Inventory Valuation For Investors: FIFO And LIFO.)

Solvency Ratios

-  Solvency ratios are used by investors to get a picture of how well a company can deal with its long-term financial obligations and develop future assets. 

-  As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt on its books.

The total debt to total assets ratio is used to determine how many of a company's assets were paid for with debt.

Total debt to total assets is calculated as follows:

When using this ratio to make an analysis of a company, it can be really helpful to look at the company's as well as making industry comparisons. It's not unrealistic for a younger company to have a debt to total assets ratio closer to "1" (more assets were financed by debt), as it hasn't yet had a chance to eliminate its debt.

As a general rule, a number close to zero is generally better, because it means that more assets were paid for without debt. Remember, lenders have first claim on a company's assets if they're forced to liquidate. But again, it will depend on the industry, as those with highly capital intensive operations will have a higher relative debt level.

Other solvency ratios include times interest earned and free cash flow (FCF). (To read on, see Debt Reckoning, Free Cash Flow: Free, But Not Always Easy and Taking Stock Of Discounted Cash Flow.)

Valuation Ratios

-  Valuation ratios are used to analyze the attractiveness of an investment in a company. 

-  The idea is that by using these ratios investors can gain an understanding of how cheap or expensive a company company's current stock price is compared to several different measures. 

-  In general, the less expensive a company is, the more attractive an investment in that company becomes.

The price to earnings (P/E) ratio is the most well-known valuation ratio that compares the company's stock price to the amount of earnings it generates on a per-share basis. An easy way to think about the P/E ratio is that it's a pretty good indicator of investors' expectations of a company's future income. That is, it's the premium that the market is willing to pay for a particular security's earnings.

The P/E ratio is calculated as follows:

-  The ratio can be compared to past levels for the company along with industry competitors and the overall market. 

-  It transforms any company's earnings into an easily comparable measure. 

-  Basically, it will tell you how much an investor are willing to pay for $1 of earnings in that company - the higher the ration, the more they are willing to spend. 

-  But don't think that a higher P/E ratio for one company necessarily suggests that its stock is overpriced. 

-  Different industries have substantially different P/E ratios, so the P/E really shouldn't be used for inter-industry comparisons. 

(To continue reading about the P/E, see Understanding The P/E Ratio, Move Over P/E, Make Way For The PEG and Are lower P/E ratio stocks always better investments?)

Other valuation ratios include price-to-book, price-to-sales and price-to-cash flow. (To see more, read Operating Cash Flow: Better Than Net Income?,Use Price-To-Sales Ratios To Value Stocks, Value By The Book and What's the difference between book and market value?)

What You Need to Know

-  Ratios are comparison points for companies. 

-  They can be used to evaluate one stock in an industry versus another in the same field. Likewise, they can be used to measure a company today against its historical numbers. 

-  It's essential to remember, though, that when using ratios to make analyses, the comparisons need to make sense. 

-  Expecting the same P/E or profitability ratio out of a textile company that you do out of a software company isn't going to help you make any valuable inferences about either company in its respective market.

Think of each industry as having a map-like scale - you wouldn't take a ruler to a globe and to a map of your hometown and expect an inch to represent the same distance on both. Keep your scales (and industries) straight and the numbers can reveal a lot.

Conclusion

-  The information you need to calculate ratios is easy to come by: Every single number or figure you need can be found in a company's financial statements (which can be found online on the company's website or on most stock quote sites). 

-  Once you have the raw data, you can plug in right into your financial analysis and put those numbers to work for you. (To learn more, see Get Organized With An Investment Analysis Form.)

Everyone wants an edge in investing but one of the best tools out there frequently is frequently misunderstood and avoided by new investors. When you understand what ratios tell you, as well as where to find all the information you need to compute them, there's no reason why you shouldn't be able to make the numbers work in your favor.

by Jonas Elmerraji

Jonas Elmerraji is the editor of the Rhino Stock Report, a new GARP investment newsletter now in free BETA.

In addition to writing for Investopedia.com, Elmerraji is a contributor to numerous business and investment publications, including TheStreet.com and Entrepreneur.

Read more: http://www.investopedia.com/articles/stocks/06/ratios.asp#ixzz1hbE8zH8W

Redefining Risk. Realistic definition of Risk.

Redefining Risk

Risk was the chance that you might not meet your long-term investment goals. 

And the greatest enemy of reaching those goals:  inflation. 

Nothing is safe from inflation. 

It's major victims are savings accounts, T-bills, bonds, and other types of fixed-income investments.

Investors usually use Treasury bills as their benchmark for risk. These are considered risk-free because their nominal value can't go down. However, T-bills and bonds are in fact highly risky because of their susceptibility to inflation.




Realistic definition of Risk

A realistic definition of risk recognizes the potential loss of capital through inflation and taxes, and includes:

1. The probability your investment will preserve your capital over your investment time horizon.

2. The probability your investments will outperform alternative investments during the period.

Short-term stock price volatility is not risk. Avoid investment advice based on volatility.

So if volatility is not risk, what is your major risk?

The major risk is not the short-term stock price volatility that many thousands of academic articles have been written about. 

Rather it is the possibility of not reaching your long-term investment goal through the growth of your funds in real terms. 

To measure monthly or quarterly volatility and call it risk - for investors who have time horizons 5, 10, 15 or even 30 years away - is a completely inappropriate definition. (David Dreman)


Take Home Lesson

Using Dreman's definition of risk, stocks are actually the safest investment out there over the long term. 

Investors who put some or most of their money into bonds and other investments on the assumption they are lowering their risk are, in fact, deluding themselves.

"Indeed, it goes against the principle we were taught from childhood - that the safest way to save was putting our money in the bank." 

What do you need to beat the market? Higher mathematical expectancy

What do you need to beat the market?  

You need to pick stocks of companies that have a higher mathematical expectancy than that of the market, example, the S&P 500. 

Of course, this could come in many forms, for example:

- a higher earnings yield (low PE), 

- better growth prospects (high EPS growth rate), 

- higher certainty in the company’s future prospects (good quality business and management), or 

- a cheaper stock price in relation to the business’s underlying assets (undervalued stock).  

There it is: simple math – no algebra, fancy spreadsheets, or Greek letters.

Do the math!

What do you need to beat the market?  

You need to pick stocks of companies that have a higher mathematical expectancy than that of the S&P 500. 

Of course, this could come in many forms, for example:

- a higher earnings yield, 

- better growth prospects, 

- higher certainty in the company’s future prospects, or 

- a cheaper stock price in relation to the business’s underlying assets.

To determine a stock’s mathematical expectancy, you need to do the math.  
For example, if you buy a stock that sells for a P/E of 30 and that you project to grow at 12% per year – something very few companies can do – for the next 10 years, what will your return be if it sells at a market-average multiple of 15 in year 10? It turns out that your return would only be about 4.5% – hardly mouthwatering! Moreover, you would have given yourself little or no margin of safety.


Buffett shared his SIMPLE MATHS on valuation..
When he spoke at Columbia in 2010, Tom Russo explained how Buffett thought about Internet valuations during the tech bubble of the late 90′s. At the shareholder meeting, a questioner pressed Buffet on why he was not buying tech stocks such as Cisco. At the time, Cisco was earning about $1 billion annually and had a market cap of approximately $500 billion. 


- Buffett started out by saying that the same $500 billion – Buffett often thinks in terms of buying the entire company – would earn $30 billion if invested in 10-year treasuries. 
- Moreover, Buffett had some doubts whether the $1 billion in earnings was solid, given such items as options. 
- So after year one, if you invested in Cisco, you would be in the hole for $29 billion in earnings. 
- Take the analysis out two years and the earnings deficit would become much bigger still. 
-  Buffett doubted a person investing on these terms would ever catch up with the earnings forfeited by not simply buying treasuries.

There it is: simple math – no algebra, fancy spreadsheets, or Greek letters.


Next time you are looking at an investment, do the math. 
-  In fact, do the math on all your current holdings, if you have not already done so. 
-  Use common sense. 
-  Make reasonable assumptions. 
-  Consider what would happen if things do not go well. 
-  Build in a margin of safety.

It is not complicated, yet many do not have the discipline to do the basic blocking and tackling that makes all the difference. Resolve today to always “do the math”.

Patience - a fundamental investment discipline to have a lot of.

What does it take to beat the market?

-   Be a focused value investor:
-  Concentrates your capital in stocks of good businesses with strong management. 
-  Be PATIENT enough to buy them at attractive prices and then hold on as they appreciate.


PRICE BEHAVIOUR in individual stocks:
-   10% of the time they’re cheap enough to buy, 
-  10% of the time they’re expensive enough to sell, and 
-  the rest of the time you should just hold them if you own them and avoid them if you don’t.”


PATIENCE is fundamental to that objective of beating the market.  
-  All the great investors agree on this point.   
-  However, most investors do not possess enough of it.

Buffett talks about investors inability to do nothing and just sit still. In distilling the essence of his investing discipline, he sings the praise of “lethargy, bordering on sloth.”

Why not double or triple your investment discipline?
(even if it cannot be measured with anything approaching precision) 
-  Resolve to wait for the S&P 500 to be off by at least 20% before making a purchase. 
-  Or insist that a stock be on the new low list before loading up. 
-  Or wait for those magical times when the yield on normalized current earnings exceeds 15%. 
-  Or wait until your relatives or friends are asking if it would not be prudent to get completely out of the stock market, or – notwithstanding your esteem for the wisdom of the Mr. Market parable – you cannot help feeling a little queasy about your own equity holdings.

However you get there, limit your buying to the 10% of the time when stocks are really cheap. 


Otherwise, just sit still and prepare.

Reference:
Google: Steve Leonard, Pacifica’s website.

'Operating Cash Flow Ratio' is sometimes a better indication of liquidity.

Definition of 'Operating Cash Flow Ratio'

A measure of how well current liabilities are covered by the cash flow generated from a company's operations.

Formula:

Investopedia explains 'Operating Cash Flow Ratio'

The operating cash flow ratio can gauge a company's liquidity in the short term. Using cash flow as opposed to income is sometimes a better indication of liquidity simply because, as we know, cash is how bills are normally paid off.


Read more: http://www.investopedia.com/terms/o/ocfratio.asp#ixzz1hW4WvJ9t