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.
TUTORIAL: Financial Ratios
The five common multiples we'll look at are EV/EBITDA, EV/Production, EV/2P, P/CF and 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.
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 to using just the multiples method. 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.)