Valuing business valuations in the oil and gas industry

Other factors will also contribute to boosting the number of mergers and acquisitions in the oil and gas sector. For example, major oil companies have aging fields and limited access to the newer sources of oil in countries such as Venezuela, Russia, and Saudi Arabia. Acquiring smaller companies is a way for large players to boost their own domestic oil and gas reserves. High energy prices and concerns over global warming are increasing demand for cleaner burning natural gas and this fuels demand for domestic natural gas producers. These companies will be targets for acquisition either by domestic competitors or by larger global firms.

Experts also predict plenty of mergers in the energy services sector. Companies that provide specialized services, such as drilling or pressurized pumping, and companies in the offshore arena are the most likely targets, especially if they generate plenty of cash.

Background

For owners of mid-size oil and gas companies, determining whether or not to sell their business, and for how much, is a challenging decision. But with the number of mergers and acquisitions increasing, this is a decision that many owners will need to consider. It is also natural for the owner of successful businesses to be curious about its market value, even if actually selling the company is the furthest thing from his or her mind. When it comes to valuing a petroleum industry business, with its inevitably complex web of tangible and intangible assets and relationships, this curiosity can come with a large price tag. Because professional valuations are expensive and are often performed when they are not really needed, business owners should be cautious about paying for this service.

Exploration and development companies, particularly the public ones, are usually fully valued by analysts today. The reason for this is the sustained high oil prices and the expectation that oil prices, in particular, will stay at lofty levels for many years to come. On the other hand, there are a great number of privately held and closely held oil field service companies that are under valued. For many years these companies sold at what was typically a 4-time multiple of EBITDA and many today are still selling in that range. However, with the explosion of business and rapid growth in the industry, these companies are experiencing in both revenue and significantly increasing EBITDA numbers the multiples are starting to move up. Allegiance Capital recently sold an oil field service company that had an adjusted EBITDA of $3.5 million for a 10-time multiple - $37 million cash at closing.

Today, it seems like there are almost as many approaches to valuing a business as there are companies and individuals selling business valuations. As noted previously, sometimes a simple multiple is applied to EBITDA numbers. There are also complex and theoretical approaches and still others that are pragmatic and focused on prices actually being paid for comparable firms. Some approaches leverage hype into dollars; others are naïve and leave out important variables. This variation creates a great deal of confusion as to the role of business valuations and what they really indicate about a business. While there are times when a professional valuation should be done, it is by no means mandatory or applicable in every circumstance.

A wide variety of situations can bring up the question of having a professional business valuation performed. A law firm may recommend one ahead of M&A negotiations to provide a quantifiable benchmark for negotiations. For wholly-owned firms, a divorce or estate planning scenario may also elicit such a recommendation. CPA firms may also recommend that a business valuation be undertaken in various circumstances, though their point of view may not be objective since they may sell valuations as part of their service package.

There are also many independent business appraisers and financial analysts that actively sell business valuations. Some of them are quite professional and can do a good job. Their qualifications should be evaluated carefully before any commitments are made. Those with professional designations issued by reputable trade associations, such as CBA, ASA, CPA/ABV, and CVA, are generally the most qualified. Because of the many special variables in the oil and gas sector, industry experience is also a plus.

Finally, there are firms advertising seminars that include promises to sell your company after they complete a business valuation. Many of these firms charge a lot of money for their valuations and seldom sell any of the companies they value. They are not true brokers or investment bankers but rather make their money from the valuations themselves.

In all cases, think carefully before deciding to undertake a valuation for your business and think carefully about who you will pay to perform it. The price for a valuation can easily run to $30,000-$50,000. Unless there is a specific reason for one and a definite time frame within which the results will be used, an expensive valuation is of little value.

When a business valuation is useful

For the owner or partner in a privately-held oil and gas company, a realistic understanding of the intrinsic value of the business by shareholders probably does not exist. Family members, partners, and investors with an emotional attachment to a business are notoriously poor at objectively gauging the market value of their “pet” enterprise.

Additionally, CPA-prepared financial reports can be very misleading on this score. Privately-held companies are not always in business to maximize the bottom-line, as this also maximizes the firm’s tax bill. They may expense many items rather than capitalizing them. Depreciation may be accelerated, inventory understated, and a variety of expenses charged to the company that would not pass scrutiny at a public corporation.

Therefore, professional valuations are useful for privately-held companies when an objective standard is needed for one or more of the following purposes:

• For estate planning
• When an owner has received an unsolicited purchase offer
• When one owner wants to buy out another
• When family members wish to be bought out
• Under forced redistribution of assets due to divorce
• To satisfy the requirements of banks and other creditors

These are a few instances where a thorough and complete business valuation - one that can stand up in a court of law - is valuable. In such cases it can serve as a benchmark in the absence of a concrete and market-verified price for the company.

Timing is critical

Business valuations have a short shelf life. Thus the criteria for having one performed should be that there is a very present need for it. A valuation is a financial snapshot taken of a company at a specific time. As time moves on, that image will change in unpredictable ways. This is easily seen in the oil and gas industry, where for example, the appraised value of an oil well can change significantly and quickly as the market price of oil spikes or plunges. A free market economy exists in a never-ending state of flux as the forces of supply and demand shift and balance against each other. In such an environment, expensive valuations are only worthwhile when the need for the information is immediate, not down the road.

The book which represents the sum total of a professional business valuation could even be out-of-date as soon as it is printed if there was a major shift in some variable while the valuation was being performed. A thorough business valuation of an oil and gas industry business must look at a multitude of variables both tangible and intangible, from production, market price, to the amount of reserves. Even location can have a bearing on the value of the business. For example, an inland, regionally focused company that is isolated from nationwide disruptions in the energy infrastructure, such as when hurricanes hamper operations in the Gulf, may see its value spike in the aftermath of a major storm. The point is that a subsequent and significant change in any of these factors will date the findings of the valuation.

As a company with many years of experience in the financial services industry, we have far too often seen a valuation book put away in a drawer. It may be reviewed at a much later date, if at all, by which time it has become nothing but a greatly overpriced paperweight. Firms that make this mistake recognize after the fact that the valuation they sunk so much money in was a static academic exercise, while the thing that really determines their firm’s value is a dynamic marketplace.

The market place is the final arbiter

The definitive value of a firm is what a buyer will pay for it, and prospective buyers typically have little interest in an owner’s purchased business valuation. Conscientious buyers do their own due diligence and determine what they are willing to offer based on their own set of criteria, and these criteria can vary from buyer to buyer.

Imagine two different potential buyers of an oil and gas company, one a strategic buyer and one a financial buyer. The strategic buyer already has a base of operations in the oil and gas industry and the acquired company would be an addition. This buyer has an established infrastructure and an extensive knowledge of the industry. Such a buyer enjoys the benefit of economies of scale, gains from common distribution channels, and the ability to eliminate redundant layers of management. All of these factors enhance the sales price the buyer is willing to pay. And these factors are not reflected in the current financial position of the company that is up for sale.

Meanwhile, the financial buyer, which incidentally might well be a private equity or buyout group, sees fewer potential advantages in the target company. This buyer will focus much harder on the demonstrated financial information of the company up for sale - its IRR, financial ratios, and so on. The financial buyer is likely to drive a much harder bargain on price, for the simple reason that the firm is not as valuable to the buyer. Currently, most of the activity within the oil and gas sector involves consolidation and integration, so a financial buyer is at a disadvantage in this market. On the other hand, with oil above $35 to $40 a barrel and demand still strong, an oil and gas business remains appealing to private investors.

The geography of potential buyers can also play an important role in determining the price they will be willing to pay. We recently sold a petrochemical company to a British firm which was very flexible in terms of pricing and concessions because the value of the British pound was far stronger at the time of the closing than at the beginning of their due diligence process, rendering them a 35% to 40% cost advantage over potential domestic buyers. Marketing a domestic oil company to a foreign buyer such as Great Britain’s BP, France’s Total, or Italy’s Eni, can be a wise move at times when the dollar is weak.

How can a business valuation take into account all of the differences between potential buyers that could affect how highly they value the company that is up for sale? It cannot.

Selling a company through an investment banker can also play a role in the market value of a company. The simple act of hiring an investment banker can drive up the price because potential buyers know they are facing a professional and savvy seller. The price is enhanced further by the investment banker’s marketing process, which drives buyers to the transaction and then pits them against each other in price, concessions and deal structure.

Once again, these are factors which can have a major impact on the price a company sells for, but which are not generally taken into account by a business valuation.

Business valuations do have their place, but they also have their limitations. They are expensive. Their accuracy is questionable and becomes more so as time passes, particularly in a fast moving market environment like that of the oil and gas industry. If you find someone recommending that your firm have a business valuation done, think slowly and carefully before deciding. OGFJ

About the author

David Mahmood [[email protected]] is founder and chairman of Allegiance Capital Corp. He has 40 years of experience from Fortune 500 companies to entrepreneurial start-ups. He has been an investment banker for the last 20 years, and has managed hundreds of complex multi-million dollar transactions in North and South America. He has served on numerous boards and industrial groups. David’s ability to create and engineer financial transactions has provided his company a strong following with business owners and shareholders.

How to maximize your firm’s valuation potential

Most valuations discount expected future cash flows into a present value, which is taken to be the firm’s market value. A typical calculation would use a current year or multi-year average of EBITDA as a representative cash flow, discounting a perpetuity of these into an NPV based on some discount rate, which represents the return on investment required by the buyer. To achieve a higher valuation for your firm:

• Increase the EBITDA
• Decrease the discount rate used
• Increase profitability
• Focus on the bottom line
• Grow revenue
• Cut costs to the minimum

The discount rate used in a valuation is largely a function of the perceived risk of the firm’s cash flows. A given level of cash flow must be discounted into a lower NPV the more uncertain that flow is. Here are ways to decrease the perceived risk of your cash flows:

• Widen your customer base: Firms which are dependent upon one or a few customers for the bulk of their revenue stand at risk of taking a large revenue hit if even one of those customers is lost. Firms with a diverse customer base can have greater confidence in their future cash flows.
• Build customer loyalty to the firm: The customer base must not be excessively dependent upon the owner of the business or someone else who may not always be around. Make sure your customer base is loyal to your firm, not just to a person who works there.

In the oil and gas industry, it is also important to carefully manage your exposure to market swings in the price of oil and gas. Wise risk management policies lower risk and raise valuation.

Case study

A senior team at Allegiance Capital recently handled the sale of an oil and gas firm for $38 million. The price that the company sold for was approximately 10 times EBITDA - which translates to quite a premium for any company. Especially since a more standard rate would be about 5 to 7 times EBITDA, which is likely what a standard valuation would have said the firm was worth.

How was this done?

First we showcased the firm’s impressive growth history. We also highlighted the new markets the firm was planning to move into. All of this worked towards increasing confidence and reducing perceived risk in the firm’s future cash flows.

We also emphasized aspects of the firm that made it an attractive candidate for acquisition, such as the fact that it could be an ideal complement for a firm without experience in the upstream space. In other words, we emphasized the value of the firm to strategic, as opposed to strictly financial, buyers. The result was a premium sale.