As with all valuations there is more than one way to go about it. I will focus on three metrics which will help me.
- Enterprise Value / production rate
- Enterprise Value / proven +probable reserves
- Enterprise Value / cash flow
- Net Present Value
Enterprise value / production rate
For those that don’t know, enterprise value is market cap + debt – cash. It is a way of analysing the value of a company ignoring the leverage effects of debt or excess cash.
The production rate of a company is disclosed in the company reports. It is also important to look at how this is changing over time and how many years the wells have been in operation. Remember in Part 3 we looked at the production curve and there are steep declines in the first few years.
The EV/PR ratio will give a number that can be compared with other companies across the sector and should give an indication of which are higher valued than others.
Enterprise value / Proven+probable reserves
I am not 100% comfortable with valuing a company based on assets that only have a 50% chance of realisation, however this is an industry norm valuation ratio and so I use it also. This again is easy to calculate from regulatory filings and can be compared across the industry.
HOWEVER, not all oil fields are made the same and this ratio does not indicate one company is cheaper than another unless they are drilling for oil in the same area. Some oil fields will produce oil faster than others hence the reserves will sell for a higher price as the cash flow will be faster and greater. It is important to only compare companies like for like.
Enterprise value / cash flow
This is one of the most important ratios. Due to the high depreciation charge for oil production (due to the exploration and development costs) profits usually understate the cash flow. Remember to add back in interest payments to cash flow as the debt has theoretically been paid in Enterprise Value.
This ratio can be compared across companies at similar stages in the production cycle, but again be careful as an old well will be worth a higher EV/CF multiple than a new well as production is declining more slowly. Also a well that costs less to operate will be worth more.
An example of a sensible EV/CF multiple for an old oil well may be 4. Using my PE ratio tool as a proxy I input -10% growth for 10 years then no more cash flow. That gives a ratio of 3.9 for a 10% return per annum.
Net Present Value at 10% discount (PV10)
Most of you probably know what a discounted cash-flow model is, well the oil industry does the hard work for us and actually calculates the net present value of future oil revenues from proved reserves (both developed and undeveloped). This is usually provided at various discount rates for comparison, but 10% is usually used across the industry.
The benefits of this measure over the EV/Cash-flow measure is that it takes account of declining well productivity on a well by well basis, as well as including direct costs of drilling and then decommissioning.
So the only thing left to deduct is the central costs of the company and any debt servicing. Central costs are usually around 5% of revenue, debt interest obviously varies.
The main weakness of the PV10 is that it predicts oil prices into the future, but that is a risk with any investment in oil producers. It also doesn’t take into account probable reserves and the unexplored land a company holds on its books that could produce oil.
Still the PV10 is by far in my opinion the best tool out of the bunch for valuing an oil company. Think of it this way, if you buy a company for its PV10 value, you are buying a 10% return per year, minus some central costs, but with the added probable reserves thrown in for free.
But that isn’t the end of the story. These metrics give a good idea of the value of the oil the company is producing or has in reserves. But most oil companies do not return this cash to shareholders, they reinvest it in exploring for new oil, drilling new wells and increasing production on existing wells. As with all investments it is important to evaluate whether management is using the cash from the business productively or destructively.
Some good proxies for this are Return on Assets (Net profit / Gross Assets) or Return on Investment ((Net Profit + Interest) / (Net Assets + Debt – Cash)).
If a company is generating returns on investment of say 5%, is that really the kind business you want your money invested in? I know I don’t, I’d rather keep my money. Alternatively if it has returns on investment of 20%, wouldn’t you be happy to let them reinvest? Thought so.
It is necessary to use a variety of metrics when valuing an oil company, and they will not give you a precise value of what it is worth. You will end up with a range of different values and will need to take into account the industry as a whole, comparing prices to recently sold wells for example.
In the final part of this series I will go through a worked example, to show these metrics in action.