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Oil is the lifeblood of all activity that takes place in the world today. Its demand is driven by an increasing population, economic activity and transportation needs. The general trend for the demand for oil has been bullish since the time oil was first discovered. Although many alternative fuel sources have been discovered over the course of the last few decades, oil still remains as the top contender for ensuring economic stability. As the world is running out of cheap oil, fluctuations in global oil prices have become more frequent. This has not only created more challenges for the oil and gas exploration and drilling companies; it has also provided them with golden opportunities.

Among all the drilling competitors, Seadrill Ltd, (SDRL) Transocean Ltd (RIG) and Ensco PLC (ESV) can be considered financially healthy. Do they have the ability to meet short- and long-term financial obligations in the long run? If you are willing to invest in the drilling industry, which stock will you consider a candidate for buying and why? This article can help you to find the answer, so let us discuss these three options.

Deep Finance Expertise

The investment valuation on Seadrill, Transocean and Ensco will be based upon 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 discounted cash flow, then the enterprise value and finally, the margin of safety. The relative method was considered as well. Now, let us walk step by step.

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 also 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:

(click to enlarge)

In my spreadsheet of the five-year period's historical data, the market capitalization of SDRL was increasing at a rate of 476% from 2008. On the other hand, the market capitalization of RIG was erratic in movement and was trending at a 12% average from 2008. In addition, ESV's market capitalization increased by 220% from 2008.

Furthermore, the takeover price to date of this writing was $27.7, $22 and $17.30 billion at $55.71, 62 and $75.04 per share for SDRL, RIG and ESV, respectively. Furthermore, total debt was greater than the cash and cash equivalents. Therefore, buying each company's entire business would require paying for the total equity plus the total debt.

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 cheaply that there was little danger of the stock prices falling further. The object 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 is: NCAV = Current Assets - Current Liabilities. The net current asset value approach of Benjamin Graham tells us that the stock price was overvalued for SDRL, RIG and ESV. Two-thirds of the net current asset value per share represents less than 10%, thus indicating that the stock was trading above the liquidation value of the company.

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 upon the assumption that two values are attached to all companies - the market price and a 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, however, 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%, than the real or true value of the stock. (click to enlarge)

Looking at table above, there was a sufficient average margin of safety for each company because the price is less than the true value of the stock for SDRL, RIG and ESV. However, RIG had a zero margin of safety in the trailing twelve months. This is due to losses suffered by RIG from 2011 to the trailing twelve months. In addition, RIG had negative earnings per share during those periods.

Let us find out the average margin of safety for SDRL, RIG and ESV. Remember the historical data, which were gathered for each company as we take into consideration the prior period's performance. SDRL, RIG and ESV have a sufficient margin of safety. Therefore, their stocks are good candidates for buying because the stocks passed the requirement of Benjamin Graham of being 40% below the true value of the stock.

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.

Here is the summary of the results of the calculations for growth:

(click to enlarge)

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, SDRL has higher growth ratios, and its payout ratio was high at 86%. However, its net margins were lower than RIG and ESV. This is how fast a company can grow using internally generated assets - without using debt or equity. Moreover, RIG shows the lowest growth. Its net margin has the highest percentage at a 56% average. On the other hand, ESV has the highest earning per share at $5.14, and its net margins were 33%.

4. A Test on Solvency and Liquidity Ratio

The solvency ratio is a measure of a company's ability to meet its long-term obligations. It determines the chances of the firm's long-term survival, while the liquidity ratio is a financial metric used to determine a company's ability to pay off its short-term debt obligations when due dates arrive.

(click to enlarge)

The resulting calculation shows that ESV has an impressive solvency ratio of 122%. This indicates that ESV has the ability to meet its long-term financial obligations. Meanwhile, SDRL and RIG have a greater probability of defaulting on their long-term debt obligations.

The debt-to-asset ratio is the percentage of the total debt financing of the company compared to the percentage of the company's total assets. The ratios above, show that SDRL and ESV have 55 and 51% of their total assets, respectively, financed by debt, and 45 and 49%, respectively, are financed by using equity. On the other hand, RIG has 36% financed by total debt and 64% financed by equity.

Furthermore, the liquidity ratios show that ESV has a larger margin of safety to cover short-term debts, while RIG has a ratio of 2.15, showing that RIG also has the ability to meet its short-term obligations. On the other hand, SDRL will be having a hard time meeting its short-term debt obligations.

4. Relative Valuation Methods

The Relative Valuation Methods for valuing a stock compares market values of the stock to the fundamentals (earnings, book value, growth multiples, cash flow, and other metrics) of the stock.

(click to enlarge)

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 stock prices were overvalued because the P/E*EPS ratios were lower than the market price.

On the other hand, the EV/EBITDA tells us that it will take 12, 5 and 10 times the cash earnings of SDRL, RIG and ESV, respectively, to recover the costs of buying the entire business of each.

The EBITDA/EV shows a 10, 13 and 12% result for SDRL, RIG and ESV, respectively. This is the percentage of the cash earnings of SDRL, RIG and ESV against the enterprise value.

Bottom Line

Overall, it indicates that the stock prices of SDRL, RIG and ESV are overvalued considering the net current asset value approach and the relative valuation. However, the companies have sufficient margins of safety, meaning the stocks are trading at a discount - below the true value of the stocks. Furthermore, SDRL will be having hard times meeting short- and long-term obligations. While RIG has the ability to meet its short-term obligations, the company shows that it may default when it comes to meeting long-term obligations. On the other hand, ESV has the capability of meeting short- and long-term obligations, and the company is financially healthy and is likely to continue its operations in the long run. Therefore, I recommend a BUY on the stock of Ensco Plc, and a HOLD on the both stocks of SDRL and RIG.

Source: Seadrill, Transocean And Ensco: Which Is The Winning Bet For Now?