Monday, March 21, 2016

Book Value Analysis of the Energy Sector

One of the most popular, timeless types of security examination is the cut-and-dry view provided by fundamental analysis. Investors who subscribe to this school of thought find buy and signals in the data of the financial statements. This form of investing, often called value investing, looks to find the best bargain on the market. Because quarterly statements only come out every three months, most trades made using fundamental analysis are long positions in the long-term. But these decisions aren't impulsive or speculative, instead, loads of data and valuation techniques can be packed behind a buy or sell signal. For this reason, it is extremely helpful to visit this perspective even if it's not an investor's specialty.

Today, we're going to be value investors and analyze energy stocks using one of the most popular tools of fundamental analysis. The book value alone represents what a potential shareholder is buying into. To calculate it, look at any balance sheet and take total liabilities from total assets. Most of the time, a company's financials will have a cell that lists the total equity or total shareholders' equity which is just another name for the book value. This number, the total equity or book value, represents the amount of money left over if a business is liquidated. Businessmen in the early to mid-20th century used this amount to measure how much they could earn if a company was taken over or taken apart for its assets. This valuation technique became slightly antiquated as traders started to focus on analyzing earnings potential for quick growth and increasing dividends.

But this isn't a throwback article, book value valuation can still be pertinent today in an analysis of the balance sheet of a company. The book value per share figure allows investors to get a general idea of how much a company's individual share is worth by dividing the stakeholders' equity over the outstanding shares. Growth (or loss) of this value over time shows how successful a business is in optimizing the use of their assets and minimizing the liabilities that take away from total equity. If book value increases, the core valuation of the company is increasing from an objective point-of-view.

An even more powerful number incorporates the objectivity of book value with the subjectivity of the group trading the market price. The market-price-to-book-value ratio compares the current share price on the market with what the financials of the company suggest a share should be worth. The ratio can also be shortened to price-to-book ratio and is used by most, if not all, fundamental value investors. There are three things to look for when calculating price-to-book ratio:

  • Price-to-book ratio is equal to 1.When this is the case, the market considers a company to be worth exactly what its financials suggests. While this will almost never happen, anything near 1 represents the idea that a company's asset is worth the dollar amount that its given. No additional earnings potential value is assigned to the firm.
  • Price-to-book ratio is less than 1. With this result, investors are told that the market values the company's assets at less than what they are worth. Typically, a value of less than 1 communicates the expectation that the company will run a loss in the future, and shareholders' equity will be taken away. This case can also accompany a buy signal if the analyst thinks that the firm is undervalued and will grow in the future.
  • Price-to-book ratio is greater than 1. Whenever a share is trading above its book value, the market is assigning extra value to a firm's asset to account for the earnings potential of the assets. There is no limit to how high a price-to-book ratio can be. A company with impressive growth potential, like Apple or Google, will typically trade at a price way beyond their book value.  At the same time, this case can generate a sell signal if an analyst believes that a market price overvalues a share.
As the stock market grew to include millions more investors and thousands more businesses, price-to-book ratios became chaotic with a high variability making large-scale comparisons relatively difficult. Now, the valuation technique is most useful when comparing individual companies within an industry. Today, a price-to-book analysis of the S&P Energy Sector will be used to show the performance of oil and gas companies over the past year. With this data, investors can see which stocks are overvalued and undervalued as well as which oil and gas firms have actually benefited their shareholders amidst the low price environment caused by the glut. 


The preliminary findings aren't exactly surprising. Of the 39 companies that were analyzed, only nine showed book value growth over the year 2015. On average, S&P oil and gas companies were worth $38.63 a share at the beginning of 2015. By the end of the year, the book values had dropped to $31.10 per share on average. That represents a change of -19.48% of shareholders' equity in the 39 firms. Investors punished this loss of fundamental value with a harsher drop in the market price. Only six companies had market share prices that were higher by the end of 2015, five of which increased their book value. On average, the market valued S&P oil and gas shares at $60.78 a share, and by the end of 2015, the same market valued them at $46.34 a share, a loss of -23.76% over the year. Already, one can see the disparity between the objective book price and contrived market price even though the difference is only about 4%. In fact on average, investors devalued these stocks at just about the same rate by which the shareholders' equity was falling. Finally, a total of eleven companies saw their price-to-book ratio rise by the end of year. The average for the 39 oil and gas companies was 1.86 and decreased to 1.74, a seemingly inconsequential change. The year change was -6.72%, which shows how investors devalued market price in tandem with book value losses.


The overall trend is only moderately interesting with losses in assets as the clear culprit of the drop in book values across the industry. Because companies are required to evaluate their assets using the current commodity spot price, the book value of these assets fell relative to what they had been valued at. On top of that, firms in need of cash to pay off short-term liabilities might liquidate assets at prices below their worth which would show up as a loss in book value. Similarly, low oil prices deflated expectations for higher earnings and caused investors to discount the shareholders' equity by over 20% on the open market. But overall, an optimistic outlook about the price of oil can be seen in the movement of the price-to-book ratio over the year. The ratio never dropped below one or came close to it. On average, traders valued the assets of oil and gas companies at 1.74x their value which seems pretty reasonable given the +50% loss in WTI contract price.

An interesting observation in the data for price-to-book ratios explains why the mergers and acquisitions scene in the oil and gas industry never erupted in 2015. Large companies shopping for cheap assets were never able to find a deal on the market because, on average, they would have been paying an extra 74-86% for any of those assets. Acquisitions don't totally make sense until a firm's price-to-book ratio drops to one or less. If that does happen, it can be bought up and liquidated for extra cash by a large firm. That result, of course, considers just averages, so individually, some companies may be undervalued and targets for a takeover.

To end, a list of interesting data points will be noted below along with what the values suggest. None of the following comments are endorsements for buy or sell signals as more research behind the data would be necessary.

  • With a 620.2% increase in its price-to-book ratio, Apache (APA) saw their book value fall by over -90%. The upside for shareholders' in this company is very limited as the market price seems overvalued. Apache will be looking to increase assets or decrease liabilities this year as a price-to-book ratio of 6.55 does not accurately represent their earnings potential. A suggestive sell for sure.
  • Cameron International (CAM) was one of four firms to increase their book value, market price, and price-to-book ratio. Shareholders' equity has only grown 2%, but its market value grew by 24%. Investors definitely have a favorable opinion of this stock and a 2.65 multiple may be a fair evaluation of its earnings potential. Look for its first quarter report for more analysis of its earnings potential. Not necessarily a suggestive buy now but could be.
  • Chesapeake (CHK) is an interesting mid-cap equity with debt problems. Its price-to-book ratio was below one for a part of 2015, but its market value tanked and stabilized it at 1.40x. Watch this company's first quarter report. It may prove to be undervalued and a good suggestive buy in a favorable price scenario.
  • CONSOL Energy (CNX) which specializes in coal and consumable fuels is very undervalued with a price-to-book ratio of 0.38. This equity is definitely a suggestive sell, though, as coal assets are beginning to lose their earnings potential.
  • After a price-to-book change of -64.1%, Kinder Morgan (KMI) is trading at a multiple below 1. Meanwhile, its shareholders' equity changed by only -1.8%. The earnings potential of this stock may be understated. The low market price translates to a suggestive buy signal.
  • Newfield Exploration (NFX) is in a situation similar to Apache. Major book value losses have led to a price-to-book multiple jump of 302.7%. This equity is very overvalued and a suggestive sell.
  • Tesoro Petroleum (TSO) and Valero Energy (VLO) are both firms who saw increases in all three categories. Shareholders' equity grew modestly with heavier gains on the market. The price-to-book multiples, both and around one and a half, represent favorable earnings potentials in an upside with the possibility of large jumps in market price. Not a suggestive buy yet, but a suggestive hold for sure.

No comments:

Post a Comment