Value is a fleeting concept, whether it involves owning a blue-chip in the Dow Jones Industrial Average, a high-profile technology company on Nasdaq, or a super-independent in the S&P 500. In general, the forward price-to-earnings ratio is by far the most widely used valuation tool. The S&P 500, for example, is currently trading at a forward price-to-earnings ratio (P/E) of about 23, which means the average stock in this index has a market value (stock price) of 23 times next-year's estimated earnings. By historical standards, the S&P 500's forward P/E has typically averaged about 17, so today's multiple has two probable implications: 1) the average company in this index is projected to grow faster than it has historically, or 2) the average company in this index is overvalued. Identifying which scenario is more likely is critical to most investment decisions, and usually involves alternative valuation techniques. Why? P/E ratios for companies in the exploration and production sector are generally not comparable to the P/E ratios of other industries, mainly because of the unique accounting standards used in the energy industry. Properly applying alternative valuation techniques in the E&P sector, therefore, can sometimes make the difference between below-average returns and windfall profits. A relative tool Conventional E&P-company valuation techniques, such as cash flow multiples, price-to-net asset value and enterprise value (EV)-to-earnings before interest, taxes, depreciation, amortization and exploration expense (EBITDAX), are typically used to identify relative distortions in market value. For example, if a company reports a negative event, such as a high-profile dry hole or a significant asset write-down, the market may overreact, causing unusual selling pressure on the stock. Investors can usually determine through the application of these techniques whether a purchase opportunity exists. A major event may cause a permanent change in relative valuation. An example of this is a large acquisition that is accretive to per-share results and that significantly alters a company's reserve life. The investor can usually determine through the use of these techniques whether a permanent change in relative valuation is warranted or if a distortion has occurred. The key word here is relative, not absolute. In our opinion, there are no absolute multiples or discounts and/or premiums that would signal a purchase or sale action, only relative ones. Influencing factors Regardless of how cheap or expensive an E&P stock might appear, there are usually several underlying reasons. They include: • The outlook for oil and gas prices, • Management's track record of meeting financial-performance expectations and adding value on a per-share basis, • The company's market capitalization (size) and the relative liquidity of its stock, • Market expectations of per-share growth, • The relative strength of the balance sheet, • The company's reserve life index, and • The relative mix of oil and gas reserves. The most significant challenge to investors and analysts alike is volatile oil and gas prices. For example, declining oil and natural gas prices have contributed to an average 23% pullback in E&P stocks since the beginning of 2001. When declines like this occur, analysts are frequently asked, at what multiple of discretionary cash flow should investors be buying these stocks? This depends on one's view of future oil and gas prices, as well as what is an appropriate multiple in an uncertain time. Our current 2002 forecast of $3 gas and $22 oil shows the E&P group trading at about 5.5 times discretionary cash flow, which is a meaningful discount to its historical average of about seven times. If one assumes that oil and gas prices in 2002 average $18 per barrel and $2.35 per thousand cubic feet (Mcf), respectively, which is line with historical averages, this group of stocks could be fairly valued. One of the alternative valuation measures we sometimes use to address price volatility is the implied in-the-ground value (IGV) of proved oil and gas reserves. In other words, when an investor purchases an E&P stock, what is he/she paying for a company's proved reserves compared to the IGV of proved reserves for transactions in the private marketplace? IGV refers to the private-market value of proved oil and gas reserves on a gas equivalent (Mcfe) or oil equivalent (BOE) basis (6 Mcf of gas = 1 barrel of oil). When an investor purchases an E&P stock, an implied IGV for proved reserves can be calculated. The first step is to calculate enterprise value (EV), which is market capitalization (stock price times shares outstanding) plus long-term debt and preferred stock. One then deducts non-oil and gas assets from EV, such as the book value of unproved acreage and third-party gas-processing facilities, and divides "adjusted EV" by total proved reserves. As shown in the chart, our universe of 22 E&P stocks reflects an average IGV of $1.01 per Mcfe. This compares with a three-year (1998-2000) average private-market acquisition cost of only 74 cents per Mcfe for U.S. proved reserves, and $1.03 for Canadian proved reserves, as calculated in Andersen's "Global E&P Trends 2001." More recent transactions, however, such as The Williams Cos.' acquisition of Barrett Resources ($1.30) and Devon's acquisition of Anderson Exploration ($1.23), reflect significantly higher IGVs for 2001. In fact, during the past 12 months the average North American private market E&P transaction has occurred at about $1.25 per Mcfe, which is a strong indication that industry believes oil and gas prices will be higher in the future. Generally, companies in private transactions pay an IGV of approximately one-third the projected wellhead price for onshore North American proved reserves and about one-half the wellhead price for U.S. Gulf Coast reserves, as the latter have a higher present value. In either case, these IGV/wellhead ratios work out to a 15% to 20% pre-tax internal rate of return on the proved reserves acquired, based on a statistical sampling of private-market transactions during the past 10 years. In our opinion, publicly traded E&P companies that are growing should trade at some premium-15% to 20%-to the average private-market IGV of proved oil and gas reserves. This premium should reflect the "going concern" component, the inherent value of management's ability to grow the enterprise. The average implied IGV of proved reserves in our universe currently reflects about a 20% discount to recent private-market proved-reserve values and roughly a 35% premium to the three-year historical U.S. average of 74 cents per Mcfe paid for proved reserves in private-market transactions. This gap is a function of the uncertain oil and gas price outlook. If gas prices move back to the $3.50 to $4.00 range in 2002, as we expect, the implied IGVs of proved reserves for our universe should increase at least 25%, which would lift the stocks back to where they were trading this past May. M Greg L. McMichael is a group leader for energy research at A.G. Edwards & Sons Inc. in Denver. Previously, he was managing director of research at Hanifen, Imhoff Inc., and spent 13 years working in the oil and gas industry.