A basic understanding of these widely-used multiples is a good introduction to the fundamentals of the oil and gas sector.
Those acronyms in full are Enterprise Value compared to earnings before interest, tax, depreciation, and amortization. It's also referred to as the enterprise multiple. This multiple is used to determine the value of an oil and gas company.
One of the main advantages of the EV/EBITDA ratio over the better-known price-earnings ratio (P/E) and the price-to-cash-flow ratio (P/CF) is that it is unaffected by a company's capital structure. If a company issued more shares, it would decrease the earnings per share, thus increasing the P/E ratio and making the company look more expensive. But its EV/EBITDA ratio would not change.
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. This is an important metric as oil and gas firms typically have a great deal of debt and the EV includes the cost of paying it off. EBITDA measures profits before interest.
A variation of the EV/EBITDA ratio is the EV/earnings before interest, taxes, depreciation, depletion, amortization and exploration expenses ratio (EBITDAX). EBITDAX is EBITDA before exploration costs for successful efforts. It is commonly used in the U.S. 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 non-cash 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 different taxes for each country.
This multiple 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.
This is enterprise value compared to daily production. Also referred to as price per flowing barrel, this is a key metric used by many oil and gas analysts. This measure takes the enterprise value (market cap + 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 amongst its peers, it is trading at a discount.
As useful 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.
This is enterprise value compared to proven and probable reserves. It's an easily calculated metric which requires no estimates or assumptions. It helps analysts understand how well its resources will support the company's operations.
Reserves can be proven, probable, or possible reserves. Proven reserves are typically known as 1P, with many analysts referring to it as P90, or 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 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. That is proven, probable, and possible reserves together. However, as possible reserves have only a 10% chance of being produced it is not as common.
This is price compared to cash flow per share. Oil and gas analysts often use this multiple. Cash flow is simply harder to manipulate than book value and P/E ratio. One disadvantage of this method is that it can be misleading in case of above average or below average financial leverage.
The calculation is simple. Take the price per share of the company that is trading and divide it by the cash flow per share. To limit the effects of volatility, a 30-day or 60-day average price can be used.
The cash flow, in this case, is the 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 sector. For the most accurate results, the share amount in calculating cash flow per share should use the fully diluted number of shares.
It is important to note that multiples expand in times of low commodity prices and decrease in times of high commodity prices.
This is enterprise value compared to debt-adjusted cash flow. The capital structures of oil and gas firms can be dramatically different. Firms 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 enterprise value and divides it by the sum of cash flow from operating activities and all financial charges including interest expense, current income taxes, and preferred shares.