In part one of this series, we looked the structure of the oil market, the defining features of the companies that comprise it and the factors affecting oil price. In part two, we will introduce some metrics commonly used to model future cash flows in order to more accurately value these businesses.
Cash is king
In dealing with oil and gas companies, there are two classes of valuation metric: profitability and efficiency of asset usage. Profitability gives an investor a measure of how valuable a company is, whereas capital efficiency is a measure of how well the company is utilizing shareholder capital.
Some of these metrics are often used in valuing businesses in other sectors, while others may be new to you. The reason why some of these more obscure methods are used relate back to the features shared by oil companies: depletion of fixed assets over time, large amounts of deployed capital and maintenance costs and typically large debt loads.
Price to annual free cash flow:Â Free cash flow is calculated by subtracting capital expenditures from operating cash flow. Why not just use operating cash flow? By subtracting capital expenditures from operating cash flow, an investor can make sure the company is maintaining its existing assets (oil reserves, pipelines, etc.) and not just juicing the earnings and cash statements by neglecting them. Additionally, investors sometimes specifically subtract maintenance capital expenditures (e.g., replacing machinery) rather than growth expenditures (e.g., drilling a new oil well) from operating cash flow to give the company credit for expanding its activities.
Price to revenue:Â While this is a less sophisticated metric than the cash flow method described above, it does have the benefit of being more difficult to game. A creative accountant can fudge earnings and cash flows, but it is much harder to spoof revenues without committing outright fraud. For this reason, it is a handy trick to have in an investor’s arsenal.
Capital efficiency ratio:Â As the name suggests, this is an efficiency metric. It is obtained by dividing net sales by net working capital. This provides a measure of how well the business is using the cash generated in its day-to-day trading activity (recall that working capital is equal to current assets minus current liabilities), and how effective it is at converting that capital into sales.
What’s wrong with price-earnings?
You will notice that one one the most commonly used valuation metrics, price-earnings, is absent from the above list. This is not a chance omission. Due to the relationship between oil price and profit margin, earnings of oil companies are often extremely volatile, which makes price-earnings an unreliable measure of value. Moreover, as we have seen, oil companies typically reinvest their earnings back into their capital-intensive businesses, which can artificially deflate earnings. For this reason, energy investors typically pay more attention to balance sheets and cash flow statements, rather than income statements.
Summary
These common valuation metrics for oil and gas companies are applicable to sectors of the industry: upstream, midstream and downstream, as well as to integrated companies. In the third and final part of this series, we will go through valuation metrics that are used specifically in the analysis of upstream oil and gas companies.
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