When it comes to raw materials, especially for fossil fuels, it’s essential to evaluate existing and potential production capabilities for such companies. Using the EV/2P Ratio is a powerful tool when evaluating fossil fuel-related companies.

Defining the Ratio

This ratio is calculated by dividing a business’ enterprise value into the company’s reserves. It provides financial analysts, investors and internal business stakeholders with a snapshot of a company’s reserves and the business’ likelihood of preserving operation growth. This standardizes valuations, thereby allowing analysts to compare company-to-company financials.

How to Calculate EV/2P

Enterprise Value (EV) / Total 2P Reserves

Defined as: Enterprise Value = Equity (open market price) + Debt (open market price) – Cash and Cash Equivalents

2P = Proven and Probable Reserves

Illustrating the Calculation

If a company’s capitalization is $300 million and debt consisting of $225 million, along with $30 million for proven reserve value, $20 million in probable reserves, and $25 million in possible reserves, the company’s resulting enterprise value becomes:

$300 million + $225 million = $525 million

The 2P reserves is:

$30 million + $20 million = $50 million

Plugging the numbers into the original formula, it’s: $525 million / $50 million = 10.5x (multiple)

Based on the resulting 10.5 multiple, this ratio provides a current valuation that translates to for every $1 in 2P reserves equals $10.50 of a market valuation.

Reserves are how internal/external stakeholders value the production/growth potential of oil/gas companies. It’s broken down into two categories:

1.) P1 are proven reserves, which are the highest caliber reserves. There’s at least a 9 in 10 percent likelihood (or more) of recoverable reserves. It’s also known as P90.

2.) Probable reserve (also known as P50) has an even chance of either non-recoverability or realized recoverability. This is the next best, but a lesser grade than P1.

These two resource categories are referred to as 2P.

Putting it in Perspective

Depending on the company’s calculated EV/2P Ratio, the business owner or investor can determine a course of action to take.

If it’s higher, it’s more highly valued than its competitors based on the same level of 2P reserves; therefore, the company’s shares are more expensive against its peers. This can give investors pause because other undervalued stocks are more attractive due to a higher likelihood they’ll appreciate.

However, if a company is valued higher, but the company is more efficient or a higher performer, investors also may be interested because its production and earnings justify the higher valuation. That’s why looking at the metric in a silo is not effective.

Debt Concerns

When it comes to debt and analyzing this ratio, fossil fuel businesses are often highly levered since they use massive sums of debt for research and development and continued operations.

Since the EV value looks at debt and equity concurrently, analyzing a company’s capital structure is essential when comparing companies’ valuations. Essentially, if a company has too much debt and if interest rates suddenly increase or it can’t service debt if the price of crude plummets, it may run into debt servicing issues.

While this ratio is effective in providing a level playing field for analytical uses, it’s important to remember that it needs to be used in conjunction with comprehensive financial analysis.

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While Cash EBITDA isn’t recognized by generally accepted accounting principles (GAAP), it’s a way for company owners and investors to account for deferred revenue during valuation modeling. This financial metric measures a business’ year-over-year change in postponed revenue to analyze a company’s financial situation.

Defining EBITDA

Before Cash EBITDA is defined, EBITDA must be defined.

EBITDA = earnings before interest, taxes, depreciation, and amortization

This metric is used quite often in financial analysis. Business owners, investors and financial analysts use this metric to examine different companies’ fiscal achievements against sector competitors and to determine the business’ profits from its core functions. 

Since financial statements are required by the U.S. Securities and Exchange Commission (SEC) and financial analysts are presented with varied filings, it still needs to be standardized for analysis. Though it’s not GAAP recognized, EBITDA and adjusted EBITDA are often reported by companies that can make peer-to-peer businesses easier to compare financials.

Some believe it’s not the best comparison due to many factors, including varying tax profiles, capital structures, and capitalization policies that affect net income. It’s important to be mindful that EBITDA doesn’t give any details regarding how a business’ working capital varies with its reinvestment into a business’ capital expenditures.

Some say EBITDA overstates profitability. Others believe EBITDA doesn’t factor in the cost of assets in evaluating profitability. For example, if two companies have the same EBITDA, but one is highly levered, the company with no to little debt is in better shape. 

Determining EBITDA

The income statement has tax expenses, net income, and interest expenses on it. If not found on the cash flow statement, the depreciation and amortization figures may be found on the financial statement footnotes. While EBITDA is a start, further refinement of EBITDA by using Cash EBITDA is a better financial definition.

Calculating Cash EBITDA

It’s important to account for deferred revenue properly. Since deferred revenue is revenue remitted in advance for products or services to be delivered at a future date, and revenue is recorded on the income statement when fulfillment happens, Cash EBITDA helps businesses and investors obtain a better picture of a company’s financial situation.

The deferred revenue or prepayment is recorded as a liability since the product or service hasn’t been delivered. Once fulfillment has occurred, it’s recognized as income. Therefore, it’s calculated as follows:

Cash EBITDA = TTM EBITDA + Year-over-Year Change in Deferred Revenue 

TTM EBITDA is the 12-month trailing EBITA. Also referred to as last twelve months (LTM), it’s the immediate 12 months of operating earnings. This way, the figure can be updated on a monthly or quarterly basis as the company adds new accounts.

The second component, derived from the balance sheet, is the annual change in deferred revenue.    

This formula is important and useful because if a new client is booked in the first three months of the year, and during a valuation analysis, if Cash EBITDA isn’t calculated, it would skew the valuation since it wouldn’t include new accounts.        

While GAAP is an important institution in the accounting and financial industry, businesses and investors that use well-regarded financial metrics beyond GAAP standards can make better-informed decisions.

With 57 percent of public companies offering their workers employee stock purchase plans (ESPPs), according to the National Association of Stock Plan Professionals (NASPP), understanding how qualifying dispositions work is an essential skill.

The concept refers to someone selling or otherwise “disposing” of equities who sees advantageous tax benefits. This is especially pronounced when a stockholder’s normal tax income rate differs markedly from prevailing tax rates for long-term investments.

Eligible individuals are those employed by a company that offers such a benefit. There are two different options available for worker participation.

The first option is where employees participate in the ESPP. The second option is through an incentive stock option plan (ISOs). It’s noteworthy to distinguish that the ESPP is for most employees employed after a particular time at a company. However, ISOs are reserved primarily for senior management and executives, such as chief financial officers (CFOs), chief executive officers (CEOs), etc.  

What determines if it’s a qualifying disposition is how long the employee keeps the equities prior to the sale.

ESPP Example

If 100 shares are acquired via ESPP, bought via a 10 percent discount to the prevailing offer of $40, the purchase of 100 shares of stock at $36 equals $3,600. If the stock appreciates to $60 in the future, the difference (and capital gain) would be $2,400 in profits ($6,000 – $3,600).

Qualifying Disposition Example

This scenario breaks down how the discount and, ultimately, how capital gains are treated.

The discount of $4 per share is taxed at the employee’s present wage rate. Depending on the tax rate the employee is taxed at, the liability would be ($4 a share, multiplied by 100, times the tax rate of 30 percent or $120).

Using the ESPP example’s figures, the long-term gain of $24 per share (times 100 shares) is taxed based on the lesser rate of say 15 percent. ($3.60/share times 100 = $360).

Therefore, the entire taxes owed end up being $120 + $360 = $480.

Non-Qualifying Disposition Example

However, for stock liquidations not meeting qualifying disposition criteria, the $2,400 would see a 35 percent capital gains tax ($2,400 multiplied by 35 percent = $840).

Based on the qualifying versus non-qualifying distribution scenarios, the difference of $360 in capital gains savings represents a stark contrast in tax obligations. Therefore, it’s important to determine how to meet a qualifying disposition.

It requires the following criteria to be met. The stock sale date must occur at a minimum of 12 months from the stock purchase date. It also must be held for at least 24 months from the ESPP offer date or the ISO stock warrant date.

While transactions may differ in the quantity of shares sold and for how much, the timing for workers selling the shares is far less variable. It is important for employers to ensure workers are familiar with the tax implications.

 

Sources

https://www.naspp.com/blog/five-trends-in-espps