The energy sector is made up of oil and gas, utilities, nuclear, coal, and alternative energy companies. But for most people, it is the exploration and production, drilling and refining of oil and gas reserves that makes the energy sector such an attractive investment. Choosing the right investment, whether that means buying stocks in an oil and gas company, an exchange-traded fund (ETF), or a mutual fund, to help you make a profit means you’ll have to do your homework, just like the professionals do.
Analysts in the oil and gas industry use five multiples to get a better idea of how companies in the industry are performing in the face of competition. These multiples tend to expand in times of low commodity prices and decrease in times of high commodity prices. A basic understanding of these widely used multiples is a good introduction to the fundamentals of the oil and gas industry.
- EV / EBITDA compares the oil and gas business to EBITDA and measures earnings before interest.
- EV / BOE / D does not take undeveloped fields into account, so investors must determine the cost of developing new fields to get an idea of the financial health of a company.
- EV / 2P requires no estimates or assumptions and helps analysts understand how well a company’s resources will support its operations.
- The price / cash flow per share allows for better comparisons across the industry.
- Many analysts prefer EV / DACF because it takes the value of the company and divides it by the sum of the cash flow from operating activities and all finance charges.
Business value / EBITDA
The first multiple we will look at is EV / EBITDA: business value compared to earnings before interest, taxes, depreciation and amortization. This multiple is also known as a business multiple.
A low index indicates that the company may be undervalued. It is useful for cross-national comparisons, as it ignores the distorting effects of different taxes for each country. The lower the multiple, the better, and when comparing the company to its peers, it could be considered undervalued if the multiple is low.
The EV / EBITDA ratio compares the debt-free oil and gas business to EBITDA. This is an important metric, as oil and gas companies often have large debt, and EV includes the cost of paying it off. EBITDA measures earnings before interest. It is used to determine the value of an oil and gas company. EV / EBITDA is often used to find candidates for acquisitions, which is common in the oil and gas industry.
Exploration costs are typically found in financial statements as exploration, abandonment and dry hole costs. Other non-cash expenses that must be added back are impairments, accumulation of asset retirement obligations, and deferred taxes.
Advantages of EV / EBITDA
One of the main advantages of EV / EBITDA over the better known price-to-earnings (P / E) and price-to-cash flow (P / CF) ratio is that it is not affected by a company’s capital structure. business. . If a company were to issue more shares, it would lower earnings per share (EPS), thereby increasing the P / E ratio and making the company appear more expensive. But its EV / EBITDA ratio would not change. If a company is highly leveraged, the P / CF ratio would be low, while the EV / EBITDA ratio would make the company appear average or wealthy.
Business value / Barrels of oil equivalent per day
This is the business value compared to daily production. Also known as price per barrel flowing, this is a key metric used by many oil and gas analysts. This measure takes the value of the company (market capitalization + debt – cash) and divides it by barrels of oil equivalent per day, or BOE / D.
All oil and gas companies report production in BOE. If the multiple is high compared to the company’s peers, it is trading at a premium. If the multiple is low among its peers, it is traded at a discount.
As useful as this metric is, it does not take into account the potential production of undeveloped fields. Investors must also determine the cost of developing new fields to get a better idea of the financial health of an oil company.
Business Value / Proven and Probable Reserves
This is the business value compared to proven and probable reserves (2P). It is an easy-to-calculate metric that requires no estimates or assumptions. Helps analysts understand how well their resources will support business operations.
Reserves can be proven, probable or possible reserves. Proved reserves are commonly known as 1P. Many analysts refer to it as P90, or having a 90% chance of occurring. Probable reserves are called P50 or have a 50% certainty of being produced. When used in conjunction with others, they are called 2Ps.
The EV / 2P ratio should not be used in isolation, as the reserves are not all the same. However, it can still be an important metric if little is known about the company’s cash flow. When this multiple is high, the company would trade a premium for a certain amount of oil on the ground. A low value would suggest a potentially undervalued company.
Because reserves are not all equal, the EV / 2P multiple should not be used alone to value a business.
EV / 3P can also be used. Those are proven, probable and possible reserves together. However, since potential reserves have only a 10% chance of occurring, it is not as common.
Price / Cash flow per share
Oil and gas analysts often use price versus cash flow per share or P / CF as a multiple. Cash flow is simply more difficult to manipulate than book value and P / E ratio.
The calculation is simple. Take the price per share of the listed company and divide it by the cash flow per share. To limit the effects of volatility, a 30 or 60 day average price can be used.
Cash flow, in this case, is operating cash flow. That number does not reflect exploration expenses, but it does include non-cash expenses, depreciation, amortization, deferred taxes, and depletion.
This method allows for better comparisons across the industry. For the most accurate results, the share amount when calculating the cash flow per share should use the fully diluted number of shares. A disadvantage of this method is that it can be misleading in the event of above or below average financial leverage.
Business Value / Debt Adjusted Cash Flow
This is EV / DACF: business value compared to debt-adjusted cash flow. The capital structures of oil and gas companies can be dramatically different. Companies with higher levels of debt will show a better P / CF ratio, which is why many analysts prefer the EV / DACF multiple.
This multiple takes the value of the business and divides it by the sum of the cash flow from operating activities and all finance charges, including interest expense, current income taxes, and preferred shares.