5 transaction multiples commonly used in oil and gas valuations

The energy sector includes oil and gas, utilities, nuclear power, coal, and alternative energy companies. But for most people, the exploration and production, drilling, and refining of oil and natural gas reserves make the energy industry an attractive investment. Choosing the right investment—whether it’s buying oil and gas company stocks, exchange-traded funds (ETFs), or mutual funds—to help you make money means you have to do your homework, just like a professional does.

Analysts in the oil and gas industry use five multiples to better understand how companies in the industry are performing against the competition. These multiples tend to expand when commodity prices are low and decrease when commodity prices are high. A basic understanding of these widely used multiples is a good introduction to the fundamentals of the oil and gas industry.

Key points

  • EV/EBITDA compares the oil and gas business with EBITDA and measures profit before interest.
  • EV/BOE/D does not consider undeveloped oil fields, so investors should determine the cost of developing new oil fields to understand the company’s financial status.
  • EV/2P does not require estimates or assumptions and can help analysts understand how the company’s resources will support its operations.
  • The price per share/cash flow can be better compared across the industry.
  • Many analysts prefer EV/DACF because it divides the corporate value by the sum of cash flow from operating activities and all financial expenses.

Enterprise Value/EBITDA

The first multiple we want to look at is EV/EBITDA-the comparison of enterprise value and earnings before interest, tax, depreciation and amortization. This multiple is also called the enterprise multiple.

A low ratio indicates that the company may be undervalued. It is useful for cross-country comparisons because it ignores the distorting effects of different taxes in each country. The lower the multiple, the better. When comparing a company with its peers, if the multiple is low, it may be considered underestimated.

The EV/EBITDA ratio compares debt-free oil and gas businesses with EBITDA. This is an important measure because oil and gas companies usually have large debts, and EVs include the cost of debt repayment. EBITDA measures profit before interest. It is used to determine the value of oil and gas companies. EV/EBITDA is usually used to find candidates for acquisition, which is common in the oil and gas industry.

Exploration costs usually appear in the financial statements in the form of exploration, abandonment and dry well costs. Other non-cash expenses that should be included include impairment, increase in asset retirement obligations, and deferred taxes.

Advantages of EV/EBITDA

One of the main advantages of the EV/EBITDA ratio over the well-known price-to-earnings ratio (P/E) and price-to-earnings ratio (P/CF) is that it is not affected by the company’s capital structure. If a company issues more shares, it will reduce earnings per share (EPS), thereby increasing the price-to-earnings ratio and making the company look more expensive. But its EV/EBITDA ratio will not change. If a company’s leverage ratio is high, the P/CF ratio will be low, and the EV/EBITDA ratio will make the company look average or rich.

Enterprise value / barrel of oil equivalent per day

This is the corporate value compared to daily production. Also known as the price per moving barrel, this is a key metric used by many oil and gas analysts. This measure takes enterprise value (market value + debt-cash) and divides it by the number of barrels of oil equivalent per day or BOE/D.

All oil and gas companies report production in BOE. If the multiple is higher than that of the company’s peers, its transaction is at a premium. If the multiple is lower among peers, the transaction is discounted.

Although this indicator is useful, it does not consider the potential production of undeveloped oil fields. Investors should also determine the cost of developing new oil fields to better understand the financial situation of the oil company.

Enterprise value/proven and probable reserves

This is the enterprise value compared to the proven reserves and the estimated reserves (2P). This is an easy-to-calculate indicator and does not require estimation or assumptions. It helps analysts understand how their resources will support the company’s operations.

Reserves can be proven, probable or probable reserves. Proved reserves are usually called 1P. Many analysts call it P90, or there is a 90% chance that it will be produced. The estimated reserves are called P50 or have a production certainty of 50%. When used in conjunction with each other, they are called 2P.

The EV/2P ratio should not be used alone, because reserves are not exactly the same. However, if little is known about the company’s cash flow, it can still be an important indicator. When this multiple is high, the company will trade a certain amount of underground oil at a premium. Low value indicates that the company may be undervalued.

Since the reserves are not exactly the same, the EV/2P multiple should not be used alone to value the company.

You can also use EV/3P. That is, proven, possible and possible reserves. However, since the possible reserves have only a 10% chance of being produced, it is not common.

Price per share/cash flow

Oil and gas analysts usually use multiples of price and cash flow per share or P/CF. Cash flow is more difficult to manipulate than book value and price-to-earnings ratio.

The calculation is simple. Divide the price per share of the company being traded by the cash flow per share. To limit the impact of volatility, 30-day or 60-day average prices can be used.

In this case, cash flow is operating cash flow. This figure does not reflect exploration expenses, but does include non-cash expenses, depreciation, amortization, deferred taxes, and depletion.

This method can better compare the entire industry. For the most accurate results, the amount of shares for calculating cash flow per share should use the number of fully diluted shares. One disadvantage of this approach is that if financial leverage is above average or below average, it can be misleading.

Corporate value/debt adjusted cash flow

This is EV/DACF-a comparison of corporate value and debt-adjusted cash flow. The capital structure of oil and gas companies can be very different. Companies with higher debt levels will show better P/CF ratios, which is why many analysts prefer EV/DACF multiples.

This multiple divides the corporate value by the sum of cash flows from operating activities and all financial expenses (including interest expenses, current income tax and preferred stock).

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