The most common tools investors use to value publicly traded companies are Earnings Per Share (EPS), Price – Earnings Ratio (P/E), Earning Before Interest, Depreciation and Amortization (EBITDA), and Discounted Cash Flows (DCF).
While these measurements might work well for a consumer products manufacturer or retail chain, they are poor metrics to employ in the valuation of an E&P company.
All of these calculations neglect the long-term outlook for an E&P Company as they don’t reflect the most critical component of the company’s health – the ability to replace reserves. They also fail to take into account the incredibly capital intensive nature of the E&P sector when compared to other industries. Finally, they fail to accurately forecast future financial performance.
As opposed to cash-flow or income statements, the balance-sheet may be the most useful tool for valuing an E&P company because it contains a description of the company’s reserves. Reserves are the truest measure of an E&P company’s value.
Let’s Talk About E&P Reserves
Before providing alternatives to EPS, EBITDA, and DCF, let’s first look at a basic methodology to value reserves.
Traditionally, reserves are classified in three manners: Proved Developed Producing (PDP), Proved Developed Non-Producing (PDNP), or Proved Undeveloped (PUD). Analysts combine their price decks for commodities with reserve reports generated by engineers to assign a value. As PDPs are less risky, they typically are valued at 90% of revenue potential, with PDNPs and PUDs valued at 50% and 10% respectively.
While EPS and P/E can take a look at a snap-shot in time, they lack the forward looking ability to correctly value an E&P company based upon reserves.
…And E&P Exploration Costs
Also, in the E&P sector EBITDA can be replaced by EBITDAX. EBITDAX is basically the same thing as EBITDA except it includes exploration expenses for successful efforts. These expenditures should be capitalized and not counted as an in-period expense. Therefore, EBITDAX provides a better reflection of an E&P company’s ability to repay a loan.
As the E&P sector is incredibly dependent on capital to exploit and expand its reserve base, EBITDAX provides a better measure of company’s ability to repay debt or to make acquisitions to replenish or “prove-out” reserves.
…And E&P Cash Flow
Modeling out DCFs for E&P companies can be difficult and irrelevant.
Due to the high CapEx requirements associated with developing or replacing reserves, DCF models can show declining valuation when in fact the E&P company could be replacing reserves at a far greater rate, thereby increasing true valuation and future viability. An alternative to DCFs would be Net Asset Value (NAV). The NAV model assumes no capital expense and no reserve replenishment. It values the production of the reserves at the current investment level over the expected life of the production. Therefore, it’s a much better measurement of a company’s financial health in the present.
The E&P industry is unique and requires non-traditional valuation metrics. DCF, EPS, and P/E ratios are irrelevant when analyzing the overall health of an E&P company. EBITDAX is a much better reflection of an E&P company’s ability to repay debts or to finance acquisitions than EBITDA. It’s important that investors factor in the nuances of the E&P sector when making financial decisions.
What do you think? Are there other factors that need to be accounted for in evaluating E&P Performance? Leave a comment below.