A lack of knowledge regarding the value of your business could be very costly. Opportunities for successful liquidity may be missed or estate planning could be incorrectly implemented based on misunderstandings about value. In addition, understanding how exploration and production companies are valued may help you consider how to grow the value of your business and maximize your return when it comes time to sell.

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Without offering a full dissertation on business valuation, you need to understand that there are three commonly accepted approaches to value: asset-based, market, and income. Approaches refer to the basis upon which value is measured. Each approach incorporates procedures that may enhance awareness about specific business attributes that may be relevant to determining the final value.

In the realm of business valuation, each approach incorporates procedures that may enhance awareness about specific economic attributes that may be relevant to determining the final value. Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) as being most indicative of value for the subject interest under consideration.

Mineral reserves are an E&P company’s main generator of value but … their value can be tricky to understand

Mineral reserves are an E&P company’s main generator of value, but because they are depleting assets and are often owned through working interests, their value can be tricky to understand.

Reserves are typically divided into two groups: proved and unproved reserves. Proved reserves are further classified as proved developed producing reserves (PDP), proved developed non-producing reserves (PDNP), and proved undeveloped reserves (PUDs); unproved reserves are further classified as probable and possible. The valuation methodology used depends on the type of reserve.

Generally, the income approach is the most supportable approach for valuing proved reserves and the market approach is generally used to value PUDs and unproved reserves.

The Asset-Based Approach

The asset-based approach can be applied in different ways, but the general idea is that the enterprise value of a business is given by subtracting the market value of liabilities from the market value of assets.

The Net Asset Value (“NAV”) method compiles the value of varying assets on a company’s balance sheet and then subtracts liabilities.  While this method can be helpful in aggregating the value of an E&P company’s assets, the value of these assets is not always readily available and sometimes must be established through other methods, such as the market approach and the income approach.  It is also helpful in asset holding companies or where the assets are more passive in nature as opposed to being operated by the same company.

The Income Approach

The income approach can be applied in several different ways. Generally, such an approach is applied through the development of an ongoing earnings or cash flow figure and the application of a multiple to those earnings based on market returns.

For companies operating in the oil and gas industry, however, a discounted cash flow analysis is most common because reserves produce unequal annual cash flows that can be projected.  This approach allows for the consideration of characteristics specific to the subject company and its reserves, such as location and well economics.

… a discounted cash flow analysis is most common valuation method used because reserves produce unequal annual cash flows that can be projected

The income approach can be used to value proved reserves because future cash flows can be projected based on the information provided by management, developed in a discrete projection, or in a reserve report.

A reserve report is typically compiled by petroleum engineers who make an estimate of reserves available during a certain production period under certain conditions. Unproved (probable and possible) reserve categories may also be estimated but are typically reported separately.

These future production estimates from reserve reports can be used to assist in projecting revenue throughout the remaining life of a well or portfolio of wells. Estimates of future cash flow can be discounted back to the present using an appropriate market derived discount rate.

The Market Approach

The market approach utilizes pricing multiples from guideline transaction data or valuation multiples from a group of publicly traded companies to develop an indication of a subject company’s value. In many ways, this approach goes straight to the heart of value: a company is worth what someone is willing to pay for it.

While geography may not factor into the selection of guideline public companies in many industries, the operational location of an E&P company is an important factor to consider

In many industries, there are ample comparable public companies that can be relied on to provide meaningful market-based indications of value. For E&P companies, such options include global integrated companies such as ExxonMobil, or larger global upstream independents such as ConocoPhillips, or a regional company such as Diamondback Energy in the Permian, or EQT Corporation in Appalachia, to name a few.

While geography may not factor into the selection of guideline public companies in many industries, the operational location of an E&P company is an important factor to consider when selecting similar companies in the oil and gas industry.  Commodity mix, profitability, and variances in drilling plans can be key considerations.  Metrics such as EV/Flowing Barrel, or EV/EBITDA can be informative, useful and indicative of value.  Drilling economics vary across plays; thus, it might not be appropriate to select a company operating in the Permian Basin as a comparable company to one operating in the Bakken Shale Play in North Dakota.

Acquisition data from industry acquisitions (typically a median from a group of transactions) can be utilized as a multiple on the subject company’s performance measure(s). This will often provide a meaningful indication of value as it typically takes into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach.

For unproved reserves, the market approach can provide a meaningful indication of value. Using an EV/acreage multiple (measuring an operator’s value as a function of their acreage) derived from transactions of similar companies or market data from comparable public company transactions, analysts can help gauge the value of a company’s unproved reserves based on the subject company’s acreage.

The market-based approach is not a perfect method. Industry transaction data may not provide for a direct consideration of specific company characteristics. Clearly, the more comparable the transactions are, the more meaningful the indication of value will be.

Synthesis of Valuation Approaches

A proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined.

A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations.

This is why industry “rules-of-thumb” (be they some multiple of revenue or earnings, or other) can be dangerous to rely on in any meaningful transaction. Such “rules of thumb” fail to consider the specific characteristics of the business and, as such, often fail to deliver insightful indications of value.

A business owner executing or planning a transition of ownership can enhance confidence in the decisions being made only through reliance on a complete and accurate valuation of the business.

For more information or to discuss a valuation or transaction-related issue in confidence, don’t hesitate to contact us.