In my previous articles (Too Many Oil Bargains: Which Is the Best Bet for Now? - Parts 1, 2, 3, 4, 5), we analyzed the top oil companies - by market capitalization, oil and gas diversified companies, oil exploration and production companies, oil and gas companies involved in unconventional oil sources from oil sands; international oil and gas exploration and production companies.
Which changes has the time brought to the oil industry? We will start analyzing two oil exploration and production companies, Apache Corp. (NYSE:APA) and Anadarko Petroleum Corp. (NYSE:APC), with another company that is currently considered a bargain in this sector, Chesapeake Energy (NYSE:CHK).
Deep Finance Expertise
The investment valuation on APC, APA and CHK will be based on the Pricing Model, which is prepared in a very simple and easy way to value a company for business valuation purposes. This valuation adopts the investment style of Benjamin Graham, the father of value investing.
My basis of valuation is the company's last five years of financial records - the balance sheet, income statement and cash flow statement. In my valuation, first I will calculate the enterprise value because this is a great measure of the total value of a firm and is often a great starting point for negotiation of a business.
1. The Enterprise Value Approach
The enterprise value is the present value of the entire company. It measures the value of the productive assets that produced its product or services, and both the equity capital (market capitalization) and debt capital. Market capitalization is the total value of the company's equity shares. In essence, it is a company's theoretical takeover price because the buyer would have to buy all of the stock and pay off the existing debt, pocketing any remaining cash. This gives the buyer solid ground for making an offer.
Going forward, let us walk through the table below as a summary for the calculation of the enterprise value:
The table shows the market value and the enterprise value for APC, APA and CHK, as well as their total debt and cash and cash equivalents. The enterprise value was greater than the market capitalization because it takes into account the equity capital and the debt capital. As shown above, the total debt was greater than the cash and cash equivalent for APC, APA and CHK. If buying the entire business, an investor would be paying 76 percent equity and 24 percent debt, 82 percent equity and 18 percent debt, and 57 percent equity and 43 percent debt, for APC, APA and CHK, respectively.
The takeover price to date for April 8, 2013, would be $53.4 billion at $106.37 per share for APC, $41.3 billion at $105.59 per share for APA and $25.5 billion at $39.71 per share for CHK. The current market price to date was $85.03, $74.20 and $19.75 per share for APC, APA and CHK, respectively.
2. The Net Current Asset Value Approach
Benjamin Graham's Net Current Asset Value (NCAV) method is well known in the value investing community. Graham was looking for firms trading so cheap that there was little danger of falling further. The concept of this method is to identify stocks trading at a discount to the company's Net Current Asset Value per Share, specifically at two-thirds or 66% of net current asset value.
The formula for the net current asset value was: NCAV = Current Assets - Current Liabilities. As shown above, the 66 percent figures were less than the market price. This indicates that the stock price was overvalued because the stock is trading above the liquidation value of the company. Therefore, it indicates that the stocks of APC, APA and CHK are not a good candidate for buying.
3. Benjamin Graham's Margin of Safety
The Margin of Safety is the difference between a company's value and its price. Value investing is based on the assumption that two values are attached to all companies - the market price and the company's business value or true value. Graham called it the intrinsic value. Value investing is buying with a sufficient margin of safety.
The question is, how large of a margin of safety is needed to be considered sufficient? Graham considers buying when the market price is considerably lower, a minimum of 40 percent, than the real or true value of the stock.
Let us find out the average margin of safety for APC, APA and CHK. Remember the historical data which were gathered for each company as we take into consideration the prior period's performance. The average margin of safety for APC, APA and CHK was 23, 8 and 34 percent, respectively. It tells us that it did not pass the requirement of Graham of being 40 percent below the true value of the stock. Therefore, the stock cannot be a candidate for buying.
Going forward, let me show you the formula for the intrinsic value or the true value of the stock, as it factors into the calculations for the margin of safety.
The formula for intrinsic value is:
Intrinsic Value = EPS * (9 + 2G)
The explanation of the calculation of intrinsic value is as follows:
EPS -- the company's last 12-month earnings per share;
G -- the company's long-term (five years) sustainable growth estimate;
9 -- the constant which represents the appropriate P/E ratio for a no-growth company as proposed by Graham (Graham proposed an 8.5, but I changed it to 9);
2 -- the average yield of high-grade corporate bonds.
Furthermore, here is the summary of the results of the calculations for growth:
The sustainable growth rate (SGR) shows how fast a company can grow using internally generated assets without issuing additional debt or equity, while the return on equity shows how many dollars of earnings result from each dollar of equity.
As shown above, the average SGR for APC, APA and CHK was 5%, 7% and -5 %, respectively, while the average return on equity was 5%, 8% and -5 %, respectively. On the other hand, the earnings per share were $2.55, $6.56 and -$0.80 for APC, APA and CHK, respectively. From the table, we see that CHK has negative growth.
4. Relative Valuation Methods
The Relative Valuation Methods for valuing a stock is to compare market values of the stock to the fundamentals (earnings, book value, growth multiples, cash flow, and other metrics) of the stock.
The Price to Earnings/Earnings Per Share (P/E*EPS) will determine whether the stock is undervalued or overvalued by multiplying the P/E ratio by the company's relative EPS and then comparing it to the enterprise value per share. The table above shows that the P/E*EPS ratio was 76, 84 and 46 percent of the price, for APC, APA and CHK, respectively. Thus, it tells us that the stock price was overvalued because the price was higher than the ratios.
On the other hand, the EV/EPS valuation is used to separate price and earnings in the enterprise value. Dividing the enterprise value by projected earnings results in the price (P/E) and the difference represents the earnings. This tells us that the price that was separated from the enterprise value was -39, -5 and 14 percent for APC, APA and CHK, respectively. The result was negative for APC because the EPS was negative due to a net loss during 2009 and 2011, which produced a higher negative result, the same as with APA during 2009, when the net earnings were negative. CHK also had negative earnings during 2009 and 2012, but the average result did not produce a negative result.
Moreover, the EV/EBITDA valuation tells us that it will take 13, 5 and 6 times the cash earnings of APC, APA and CHK, respectively, to cover the costs of buying the entire business. In other words, it will take 13, 5 and 6 years to recover the costs of buying.
Overall, it indicates that the shares of APC, APA and CHK are expensive. In addition, there was not enough margin of safety for buying. Therefore, I recommend a HOLD on the stock of Anadarko Petroleum Corporation and the Apache Corporation. Further, I recommend a sell on the stock of Chesapeake Energy.