Valuation methods: book value and market value

Quick refresher

Book value is the cost of creating or buying an asset minus the depreciation and impairment (a write-down when the asset has lost value) accumulated so far. Market value is the price at which the asset would change hands on the valuation date between informed parties, neither of whom is forced to deal. Value from cash flow is the present value (what the asset's future flows are worth today) at the investor's rate.
Fields are usually depreciated in proportion to production: the share of the cost written off in a year equals the share of reserves produced in that year. The depreciation scheme changes the book value, but it does not change a single barrel of future production.
The book value of a field is the not-yet-written-off cost of finding, buying and developing it, not the worth of its oil today. In the lesson's example, after the first year of production the field is worth $260 million from cash flow and $139 million on the balance sheet.
If the present value of future flows has fallen below the book value, for example after a cut in the price outlook, the asset is impaired. This means that it is written down (its book value is reduced) to its recoverable amount, which is what it can still bring in.
Comparable deals and multiples are quick, but they carry over the conditions of other assets: the reserves category, the cash flow per barrel, the field life, taxes, the oil price on the date of the deal. Without adjustments they can easily be wrong by one and a half to two times.
We value an exploration and production company as the sum of its parts (NAV): the value of each asset from its risk-adjusted cash flow, minus overheads (the general costs of running the company) and net debt (debt minus cash). We do not average the results of different methods. We cross-check them and look for the reasons for the differences.

Key relationships

B_n = C_0 - \sum_{t=1}^{n} D_t

book value after $n$ years: the initial cost less accumulated depreciation

D_t = C_0\,\dfrac{q_t}{R}

unit-of-production depreciation: the share of reserves $R$ produced in the year

\mathrm{EV} = E + D - \mathrm{Cash}

enterprise value: market capitalisation (the value of all the company's shares) plus debt minus cash

\mathrm{NAV} = \sum_j V_j - PV_{\text{OH}} - (D - \mathrm{Cash})

equity as the sum of discounted parts

L = \max\left[0;\ B - \max(FV - c,\ VIU)\right]

impairment loss: arises when the book value is above the recoverable amount

Common pitfalls

Taking the book value for the price of a field or a company.
Applying the price per barrel of reserves from comparable deals without checking the reserves category, the cash flow per barrel, the field life, the tax regime and the date of the deal.
Adding the replacement cost of a field's pipelines and facilities (what it would cost to build them again) to the field's DCF value (its value from discounted cash flow): this counts the same thing twice.
Deducting an abandonment provision (money set aside to close the wells and facilities) from NAV when abandonment costs are already in the field's cash flow.
Multiplying the peak-year EBITDA (earnings before interest, taxes, depreciation and amortisation) of a depleting field by the multiple of companies with long-lived reserves.

After this lesson you can

distinguish book value, market value and value from cash flow, and explain which question each answers
calculate depreciation (writing off the cost of an asset year by year) by the straight-line method, the declining-balance method and in proportion to production, and find the book value of an asset
explain why the book value of an oil and gas asset differs from its worth: inflation, dry holes, reserves that do not appear on the balance sheet, impairment
value an asset and a company from comparable deals and multiples (dollars per barrel of reserves, and EV/EBITDA, which is the value of the company divided by its yearly operating earnings), with adjustments for the quality of the asset
build up the value of a company from discounted parts (NAV), apply replacement cost, and cross-check the results of different methods

What an asset is worth: three answers to one question

We have to value very different things: a right to a subsoil area together with its reserves, a well or a pipeline, an interest in a project, a whole company. In accounting, all of these are assets: resources that a company controls and from which it expects future economic benefits. The reasons for valuation are also varied:

the purchase or sale of a field, an interest in a contract or a whole company — mergers and acquisitions
a partner entering a project, a farm-out (passing an interest to a partner; working interests and their transfer)
a loan secured on property or on the cash flow of a project
annual reporting and tax calculations
decisions inside the company: whether to sell a mature field, whether to invest in development (Net present value (NPV))
deals involving the state: in Kazakhstan, when a subsoil use right to a strategic area is sold, the state may buy it at a price no worse than the one stated, and when the right is transferred without payment, at the market price (priority right)

There are three answers to the question “how much is it worth?”. They are called approaches to valuation: the cost approach, the comparative (market) approach and the income approach.

Three approaches to valuation

Approach: Cost (book value, replacement cost)
Question: How much has been put into the asset, or what would it cost to create an equivalent one?
Relies on: past costs or today's construction prices
Main weakness: does not see what the asset will earn; does not reflect reserves in the ground

Approach: Comparative (market value)
Question: What do similar assets sell for?
Relies on: deal prices and share prices
Main weakness: there are few similar deals, and each has its own conditions

Approach: Income (from cash flow)
Question: What will the asset earn in the future?
Relies on: a forecast of production, prices, costs and taxes, and a discount rate
Main weakness: depends on assumptions about the future

Approach	Question	Relies on	Main weakness
Cost (book value, replacement cost)	How much has been put into the asset, or what would it cost to create an equivalent one?	past costs or today's construction prices	does not see what the asset will earn; does not reflect reserves in the ground
Comparative (market value)	What do similar assets sell for?	deal prices and share prices	there are few similar deals, and each has its own conditions
Income (from cash flow)	What will the asset earn in the future?	a forecast of production, prices, costs and taxes, and a discount rate	depends on assumptions about the future

The approaches complement each other. The income approach shows what the asset ought to be worth, the comparative approach shows what people pay for such assets, and the cost approach shows how much has been put into the asset.

Book value and depreciation

Book value (carrying amount) is the amount at which an asset is recorded in the balance sheet (the statement of what a company owns and owes): the cost of creating or buying it minus the accumulated depreciation and impairment losses. It is also called the accounting value or the net book value. This approach looks to the past: the value of an asset is decided by how much was paid for it.

Book value (net book value) of an asset

B_n = C_0 - \sum_{t=1}^{n} D_t

where:

$B_n$ book value after $n$ years of operation, US$ million
$C_0$ initial cost: the cost of creating or buying the asset, US$ million
$D_t$ depreciation in year $t$ (together with the impairment loss, if there was one), US$ million
$n$ number of years elapsed, years

Units: reporting currency

Holds when

the asset is carried at actual cost; revaluation is not considered here
over the whole life, depreciation adds up to the initial cost minus the salvage value; the scheme decides only how this sum is spread over the years

Book value is the cost that the company has not yet moved into its expenses. It says nothing about what the asset will earn.

Depreciation moves the cost of an asset into expenses in parts, while the asset is working. It is not a payment: the money went out earlier, when the asset was bought (profit and cash flow). It is also not a measurement of wear. It is an accounting rule. The company chooses a method that roughly follows how the asset gives its benefit, and it changes the method only if this pattern has clearly changed. The international financial reporting standard on property, plant and equipment, IAS 16, names three common methods.

Straight-line depreciation

D_t = \frac{C_0 - S}{N}, \qquad B_n = C_0 - n\,\frac{C_0 - S}{N}

where:

$D_t$ depreciation in year $t$ — the same every year, US$ million
$S$ salvage value — what the asset can be sold for at the end of its life, minus disposal costs (often taken as 0), US$ million
$N$ useful life, years
$C_0,\ B_n,\ n$ as in the book value formula, US$ million, years

Units: any consistent units

Holds when

the life $N$ and the salvage value are estimated in advance and reviewed at least once a year; a review changes the depreciation of future years, and past years are not recalculated

The value falls by the same amount every year. This is the simplest scheme. It suits buildings, pipelines and equipment with a steady load.

Declining-balance depreciation

D_t = a\,B_{t-1}, \qquad B_n = C_0\,(1 - a)^{n}, \qquad a = \frac{k}{N}

where:

$a$ depreciation rate — the share of the remaining balance written off in a year, fraction
$k$ acceleration factor: 1 for simple declining balance, 2 for double-declining balance, —
$B_{t-1}$ book value at the start of year $t$ , US$ million
$N$ useful life, years

Units: any consistent units

Holds when

the balance never reaches zero, so at the end of the life it is written off in full, or the method switches to straight-line write-off of the balance

More is written off in the early years and less in the later ones. This suits machines and equipment, which lose their resale value quickly.

Unit-of-production depreciation

D_t = C_0\,\frac{q_t}{R}, \qquad B_n = C_0\left(1 - \frac{Q_n}{R}\right)

where:

$q_t$ production in year $t$ , million bbl
$Q_n$ cumulative production over $n$ years, million bbl
$R$ reserves over which the asset is depreciated (the basis follows the company's accounting policy: proved, or proved plus probable; for development costs, often the developed reserves), million bbl
$C_0$ capitalised costs of the field, US$ million

Units: any consistent units: production and reserves in the same units

Holds when

reserves are not revised; on a revision the remaining cost is divided by the new remaining reserves, so only future years change (advanced section)
the asset serves while it is being produced from: when production stops, there is no depreciation

A field loses its value not with time but as reserves are extracted from it. That is why oil and gas assets most often use unit-of-production depreciation, which is also called depletion.

In Kazakhstan, subsoil users are classed as public-interest entities, except those who extract common minerals (such as sand and gravel). They must prepare their financial statements under the international standards, IFRS (Law “On Accounting and Financial Reporting” of 2007, Articles 1 and 2). For tax, depreciation is calculated under the rules of the Tax Code. So the value of an asset in the financial statements and its value for tax usually differ. In the project model of the library's examples, tax depreciation is set separately: in equal parts over 5 years (payments to the state in the model).

Worked exampleBook value of a field under three schemes

Given (assumed data)

Field: the project from the library's examples (its cash flow): development — US$160 million over years 1–3
Production: 1.6; 2.4; 2.4; 2.0; 1.6; 1.2 and 0.8 million bbl in years 3–9, 12 million bbl in all
Life for the straight-line and declining-balance schemes: 7 years of production, salvage value 0
Valuation date: end of year 5 — after three years of production

Solution

Straight-line scheme: $160/7 = 22.857$ million dollars a year; after three years $160 - 3\cdot22.857 = 91.43$ million dollars.
Double-declining balance: the rate is $2/7$ ; after three years $160\cdot(5/7)^{3} = 160\cdot0.36443 = 58.31$ million dollars.
In proportion to production: $1.6 + 2.4 + 2.4 = 6.4$ million bbl of the 12 have been produced, so $160\cdot(1 - 6.4/12) = 74.67$ million dollars.
The value of the remaining flow — years 6–10 — at the end of year 5 at 10%: $65.6/1.1^{0.5} + 52.8/1.1^{1.5} + 33.6/1.1^{2.5}$ $+ 20.8/1.1^{3.5} - 12/1.1^{4.5}$ $= 62.5 + 45.8 + 26.5 + 14.9 - 7.8 = 141.9$ million dollars.

Answer: After three years of production the field is carried on the balance sheet at 91.43, 58.31 or 74.67 million dollars, depending on the scheme; its remaining cash flow is worth 141.9 million dollars.

What it means. The depreciation scheme changes the book value by about one and a half times, but it does not change a single barrel of production or a single dollar of future flow. The economic value is almost twice the book value: the balance sheet shows costs not yet moved into expenses, not future income. The unit-of-production scheme follows the real change in value most closely: it writes the cost off when the reserves are actually extracted. For simplicity we leave future abandonment out of the book value (under IFRS it is recorded as a provision, money set aside for a future cost, and added to the cost of the asset). The data in this example are assumed for illustration.

CalculatedBook value of the example field under three depreciation schemes, and the value of its remaining cash flow at 10% at the end of each project year. In the development years the book value grows by the amount invested, in the production years it falls; the economic value at the end of the life is negative: only abandonment lies ahead.

Where book value departs from worth

Book value is easy to check against documents, which is why reporting and taxes are built on it. But for oil and gas assets it differs from worth, and the main reason lies in the reserves themselves.

Reserves off the balance sheet. The value of a field on the balance sheet includes what the company paid for: the right to use the subsoil, exploration, drilling and development. If the field was bought, the purchase price is added. That price is the worth of the reserves as it was seen on the day of the deal, and it also goes into depreciation. The worth of oil that the company found itself does not appear on the balance sheet. Reports disclose reserves as quantities, in barrels and tonnes. In the US they also disclose the value of the future flows from proved reserves, discounted at 10% (where the 10% comes from). That is why the book value of a company that found its fields itself is often much lower than its market value. Do not confuse worth with the gross “value of reserves” either. This is the volume multiplied by the price of the raw material, and Kazakhstan calculates the starting signature bonus (the first payment to the state for a subsoil use right) from it (categories and money). For the field of the examples it is $12\cdot50 = 600$ million dollars, while the NPV of its development is about 100 million dollars.

Exploration costs. Money spent on exploration wells and seismic surveys can be charged to expense at once, or capitalised, which means included in the cost of the asset. Under the successful efforts method, only the costs that led to a discovery are capitalised, and dry holes (wells that found no oil) are written off at once. Under the full cost method, all exploration costs within a country or another cost centre (a unit whose costs are totalled together), successful or not, are capitalised. They are then depreciated together as production proceeds. In the US both methods are permitted. IFRS 6 allows a company to keep its existing way of accounting for exploration and evaluation expenditure. But once the commercial viability of a discovery has been shown, these costs are moved into the field's assets and tested for impairment. The company's accounting policy states which method it has chosen.

Worked exampleFour exploration wells on the balance sheet

Given (assumed data)

Wells of the year: $9, $11, $7 and $13 million; the well that cost $11 million made a discovery, the others were dry
Reserves of the discovery: 10 million bbl (development will begin in a few years)

Solution

Successful efforts method: 11 million dollars is capitalised as an asset, and $9 + 7 + 13 = 29$ million dollars goes to the expenses of the year.
Full cost method: all of it, $9 + 11 + 7 + 13 = 40$ million dollars, is capitalised, and 0 goes to the expenses of the year.
When production starts, the exploration costs are depreciated by production: $11/10 = 1.1$ dollars per barrel under the first method and $40/10 = 4.0$ under the second.

Answer: Under the full cost method the company has 29 million dollars more pre-tax profit this year and the same amount more assets, while later each barrel of the field carries 2.9 dollars more depreciation.

What it means. Over the whole life of the field the two companies will write off the same 40 million dollars. Only the timing differs. In years of active exploration the reporting of the full-cost company looks better, and its balance sheet carries the “value” of dry holes that will bring nothing, although they did provide information about the subsurface. The cash flow does not change with the choice of method (tax is calculated by its own rules). When analysts compare the profits and balance sheets of companies, they check which method each company uses. The data in this example are assumed for illustration.

Inflation. Costs are recorded in the money of the year of purchase. They are not recalculated as prices rise, while depreciation reduces them year after year. So a pipeline or a plant built twenty years ago stands on the balance sheet at a low value, although building it again would cost several times more. The oil pipeline example below shows this (Inflation: nominal and real money).

Impairment. If the book value turns out to be higher than what the asset can earn, the financial statements must recognise this. Under IAS 36, a company tests an asset for impairment (a loss of value) when there are signs of one: prices have fallen, reserves have been revised downward, costs have risen, or taxes have changed. It compares the book value with the recoverable amount, which is the greater of two amounts: the selling price minus the costs of disposal, and the value in use, that is, the present value of the flows from the continued operation of the asset. If the recoverable amount is lower, the difference is written off as a loss.

Impairment loss

L = \max\left[0;\ B - \max\left(FV - c,\ VIU\right)\right]

where:

$L$ impairment loss, by which the book value is reduced, US$ million
$B$ book value of the asset or group of assets, US$ million
$FV - c$ fair value less costs of disposal, US$ million
$VIU$ value in use: the present value of the flows from the continued operation of the asset, US$ million

Units: reporting currency

Holds when

the smallest group of assets that generates independent cash flows is tested — for oil, usually a field or a group of fields with shared infrastructure
under the standard, value in use is calculated from pre-tax flows and a pre-tax rate; the fair value of oil and gas assets is often estimated from the after-tax flow — as a buyer would see it
under IFRS an impairment loss can be reversed if prices have recovered (except for goodwill, the extra price paid for a business above the value of its assets), but not above the value there would have been without the impairment

Impairment does not change this year's cash flow: it is a recognition in the financial statements that the money invested will not be fully recovered. After that the asset is depreciated from its new, lower value.

Worked exampleThe price outlook has fallen: should the field be impaired

Given (assumed data)

Field: the same one; end of project year 3, the first year of production is behind
Book value: unit of production, excluding abandonment
New long-term price outlook for years 4–10: $35/bbl, in the second case $26/bbl (assumed)
Recoverable amount: a fair value estimate from the after-tax flow at 10%; costs of disposal are ignored

Solution

Book value: $160\cdot(1 - 1.6/12) = 138.67$ million dollars.
At $35/bbl the project model gives a flow for years 4–10 of 52.48; 52.48; 44.00; 35.52; 20.64; 12.16 and −12 million dollars. Its value at the end of year 3 is 169.82 million dollars, which is $169.82 - 138.67 = 31.15$ million more than the book value: there is no impairment.
At $26/bbl the value of the flow is 115.60 million dollars, less than the book value: the impairment loss is $138.67 - 115.60 = 23.07$ million dollars.
The new book value is 115.60 million dollars; from then on, unit-of-production depreciation is $115.60/10.4 = 11.12$ dollars per barrel instead of $160/12 = 13.33$ .
Threshold: the value of the flow equals the book value at a price of about 29.8 $/bbl.

Answer: At an outlook of $35/bbl the field passes the test with a headroom of 31.15 million dollars; at $26/bbl it is written down by 23.07 million dollars; the boundary is about 29.8 $/bbl.

What it means. Impairment changes neither the flows nor the taxes of the year, because tax depreciation is calculated by its own rules. But for a reader of the financial statements it is a signal: the company itself has admitted that its outlook for price, costs or reserves has worsened. The threshold in the example is low because the field is cheap to produce. For projects with a thin margin and a long payback, impairment sets in at a much smaller fall in the price. The data in this example are assumed for illustration.

Market value: what deals tell us

Market value is an estimate of the price at which an asset would change hands on the valuation date. The Law “On Valuation Activity in the Republic of Kazakhstan” of 2018 defines it in Article 1 as the estimated sum of money for which the asset would be exchanged on the valuation date between an interested person and a seller. The deal is a commercial one, made after proper marketing, and each party acts knowledgeably, prudently and without compulsion. A related IFRS concept is fair value: the price that would be received on selling the asset in an orderly deal between market participants on the valuation date.

We derive market value from the prices of deals in similar assets. A deal is suitable as a comparable if it is close to the conditions of the definition: the parties are independent and know the asset well, no one is pressing the seller, and the asset was offered to many buyers. A sale of “one's own” company within a group, a sale to repay debt, or a deal with a single invited buyer says little about market value. The comparable must also be similar in the type and quality of the reserves, the contract terms and the remoteness. And the deal must be recent, because the value of assets moves with the oil price (Market, financial and regulatory uncertainty). Only a few fields in one basin are sold in a year, so suitable deals are almost always few, and each one has to be adjusted.

The market for assets goes in cycles. In years of expensive oil there are more buyers than sellers, and deal prices rise. When oil gets cheaper, many are forced to sell, above all companies with large debts, and assets get cheaper. A market valuation is a snapshot of one moment in this cycle.

To compare assets of different sizes, we divide the price of a deal by a measure of size. The result is a multiple:

dollars per barrel of reserves — the price divided by 2P reserves (proved plus probable) or 1P (proved only); for discoveries with no development decision, by 2C contingent resources (oil that may be recoverable but is not yet commercial; Classification of reserves and resources)
dollars per barrel of daily production — the price divided by production in bbl/d; convenient for mature fields with steady production
EV/EBITDA — for companies: enterprise value divided by earnings before interest, taxes, depreciation and amortisation

Enterprise value (EV)

\mathrm{EV} = E + D - \mathrm{Cash}

where:

$\mathrm{EV}$ enterprise value: the value of its business to everyone who has provided it with capital — shareholders and lenders, US$ million
$E$ market value of equity — market capitalisation: the share price multiplied by the number of shares, US$ million
$D$ debt: loans, bonds and similar obligations, US$ million
$\mathrm{Cash}$ cash and cash equivalents, US$ million

Units: one currency and one date for all the terms

Holds when

non-controlling interests (shares in subsidiaries that belong to outside owners) and preferred shares, if there are any, are added to EV
the obligations included in debt are the same for the companies being compared — for example, leases or an abandonment provision — otherwise the multiples are not comparable
EV relates to the same assets as the measure in the denominator of the multiple

EV does not depend on how the company is financed. If the company issues shares and repays debt with the money, $E$ and $D$ change, but EV does not. That is why we compare EV with measures taken before payments to lenders: EBITDA, reserves and production. We find the value of the shares by working backwards: $E = \mathrm{EV} - (D - \mathrm{Cash})$ .

EBITDA: Earnings before interest, taxes, depreciation and amortisation. It is revenue minus operating costs, payments based on revenue (royalty, mineral extraction tax) and overheads. Depreciation, interest and income tax are not deducted. It is the money the business earns before investment, payments to lenders and income tax.
Market capitalisation: The market value of a company's shares: the exchange price of a share multiplied by the number of shares outstanding.
P/B (price to book): Market capitalisation divided by the book value of equity. For oil companies it is often above one, because reserves are not shown at their worth on the balance sheet. But at low oil prices it can also be below one.

Value from cash flow: an asset and a company

The income approach values an asset in the same way as an investment decision. We forecast the cash flow (production, prices, costs, taxes, abandonment; Cash flow model of an oil and gas project) and bring it back to the valuation date at the buyer's rate (Net present value (NPV), Choosing the discount rate). The NPV (net present value) at the buyer's rate is the highest price that the buyer can pay and still earn its required return (the decision rule). A few details make the valuation of a deal different from the appraisal of a project.

The valuation date is the date of the deal, not the start of the project. Costs already spent are not included in the calculation (which flows belong to the decision).
The price scenario (price deck) is an agreed price forecast. Often the first years follow futures prices (the prices of contracts for future delivery), and later years follow the company's long-term price. The value depends on it more than on anything else (Market, financial and regulatory uncertainty).
Risk by category. Reserves with a development decision are valued from the production forecast. Discoveries without such a decision are valued with a probability of development. Exploration areas are valued by expected monetary value (Expected monetary value and preference theory).
The buyer's position. After the deal, taxes and costs are calculated as they will be for the buyer: its tax losses, its facilities nearby, its cost of capital.

We value an exploration and production company as the sum of its parts. Each asset is valued from its own cash flow, adjusted for risk. Then we subtract what was not included in the asset flows, and we convert the value of the business into the value of the shares.

Net asset value (NAV)

\mathrm{NAV} = \sum_{j} V_j - PV_{\text{OH}} - (D - \mathrm{Cash})

where:

$\mathrm{NAV}$ net asset value — an estimate of equity as the sum of parts, US$ million
$V_j$ value of asset $j$ from its risk-adjusted cash flow at the valuation date, US$ million
$PV_{\text{OH}}$ present value of general (corporate) overheads not included in the asset flows, US$ million
$D - \mathrm{Cash}$ net debt, US$ million

Units: one currency, one price scenario, one rate and one date for all the parts

Holds when

each flow is counted once: if abandonment, taxes or overheads are already in an asset's flow, they are not subtracted again
the parts are added only if the assets are independent; shared infrastructure and mutual benefits require a common flow
$\sum_j V_j - PV_{\text{OH}}$ is the value of the business (EV), and NAV is what is left for the shareholders

NAV is what the shares would be worth if the company ran its assets to the end of their life and found nothing beyond what has been valued. The market may pay more (it expects new discoveries and successful deals) or less (it doubts the forecast and takes account of risks and management costs).

Worked exampleA company with one field: valuation by the sum of its parts

Given (assumed data)

Valuation date: end of project year 3 of field A: the first year of production is behind
Field A: the project from the library's examples; 10.4 million bbl of 2P reserves remain; the flow for years 4–10 at $50/bbl is 78.4; 78.4; 65.6; 52.8; 33.6; 20.8 and −12 million dollars
Discovery B: 8 million bbl of 2C contingent resources; appraisal work costing $6 million in the next six months; a decision a year from now: with a probability of 0.6, development with an NPV of $45 million at the date of the decision, otherwise the discovery is dropped
Licence C: a prospect (a possible trap for oil that has not been drilled yet) with a probability of success of 0.2; a discovery would be worth $70 million, the exploration well costs $10 million (both amounts at the valuation date)
Company overheads: $3 million a year for 7 more years (for simplicity, their tax saving is ignored — this slightly understates the valuation)
Debt and cash: $70 million and $15 million
Rate: 10% (real), flows in the middle of the year
Balance sheet: the field by unit of production; exploration and evaluation costs of B and C — $12 million and $3 million

Solution

Field A: the flow for years 4–10, discounted with exponents $0.5;\ 1.5 \ldots 6.5$ , is 260.0 million dollars, or 25.0 dollars per barrel of remaining reserves.
Discovery B: $-6/1.1^{0.5} + 0.6\cdot45/1.1 = -5.7 + 24.5 = 18.8$ million dollars.
Licence C: $\mathrm{EMV} = 0.2\cdot70 - 10 = 4.0$ million dollars (EMV of an exploration well).
Overheads: $3\cdot\sum_{k=0}^{6} 1.1^{-(k+0.5)} = 15.3$ million dollars.
Value of the business: $260.0 + 18.8 + 4.0 - 15.3 = 267.5$ million dollars; of the equity: $267.5 - (70 - 15) = 212.5$ million dollars.
On the balance sheet: the field $160\cdot(1 - 1.6/12) = 138.7$ , exploration and evaluation costs $12 + 3 = 15$ , cash 15, debt 70; equity $138.7 + 15 + 15 - 70 = 98.7$ million dollars.

Answer: The company's equity is worth about 212.5 million dollars by the sum of the parts — 2.2 times the book value of 98.7 million dollars.

What it means. Almost all the value comes from field A. By cash flow it is worth 121 million dollars more than on the balance sheet: the balance sheet holds costs not yet written off, and the valuation holds the oil that will be produced. Discovery B is worth more than its appraisal costs only because there is a probability of development. Licence C is worth little because the chance of success is small. We did not subtract an abandonment provision separately, because its costs are already in the field's flow (−12 million dollars in year 10). The data in this example are assumed for illustration.

The cost approach: what it would cost to build anew

For objects that are rarely sold, and whose flows are hard to separate from the field's flows, we use replacement cost. Such objects are pipelines, treatment plants, tanks and field roads. Replacement cost is what it would cost today to create an object of the same usefulness, minus its wear and obsolescence (being out of date). It is used for insurance, collateral, revaluation of property in the financial statements, and as a check on other valuations.

Depreciated replacement cost

C_{\text{repl}} = C_{\text{new}}\left(1 - \frac{\tau}{T}\right)(1 - k_{\text{func}})

where:

$C_{\text{repl}}$ replacement cost less physical deterioration and functional obsolescence, billion tenge or US$ million
$C_{\text{new}}$ cost of creating an object of the same usefulness at current prices, billion tenge or US$ million
$\tau,\ T$ age of the object and its service life, years
$k_{\text{func}}$ functional obsolescence — the share of value lost because the object is oversized or outdated compared with a modern equivalent, fraction

Units: any currency; current prices

Holds when

physical deterioration is taken as proportional to age; in practice it is also assessed from the condition of the object
external (economic) obsolescence — the loss of value because the object has nothing to do — is taken into account separately, by comparison with the income the object can earn

Replacement cost is a ceiling on the price: no one will pay more for an old object than a new one with the same usefulness costs. But an object is worth no more than it can earn.

Worked exampleAn oil pipeline: book value, replacement and income

Given (assumed data)

Oil pipeline: built 14 years ago for 9.0 billion tenge (KZT); service life 35 years
Pipeline construction cost index over 14 years: 3.1 (assumed)
Functional obsolescence: 20%: the pipe was designed for production that disappeared long ago
Income: net tariff income of 1.5 billion tenge a year for another 6 years, while the fields it serves are producing; rate 12% in tenge

Solution

Book value (straight-line, no revaluation): $9.0\cdot(1 - 14/35) = 5.40$ billion tenge.
Cost of creating it today: $9.0\cdot3.1 = 27.90$ billion tenge; less physical deterioration $27.90\cdot(1 - 14/35) = 16.74$ ; less functional obsolescence $16.74\cdot(1 - 0.2) = 13.39$ billion tenge.
The income that the pipeline will still earn: $1.5\cdot\dfrac{1 - 1.12^{-6}}{0.12} = 1.5\cdot4.1114 = 6.17$ billion tenge (annuity factor).
Economic obsolescence: $13.39 - 6.17 = 7.22$ billion tenge — the part of the replacement cost that the income does not support.

Answer: The pipeline is worth about 6.17 billion tenge: its depreciated replacement cost (13.39 billion tenge) is higher than what it can earn.

What it means. The three numbers answer different questions. The balance sheet (5.40 billion tenge) shows costs not yet written off, in the tenge of 14 years ago. After the rise in prices it says little. The replacement cost (13.39 billion tenge) is a price ceiling. But the ceiling cannot be reached if the object has nothing to pump: the buyer will pay no more than the discounted income. The cost approach is good for objects with a long and reliable throughput. For the objects of depleting fields we check it against income. The data in this example are assumed for illustration.

One company — several valuations

Now we value the company of the example by the comparative approach too, as well as by the sum of its parts. Suppose we know four recent deals in producing fields of a similar basin, and the multiples of four listed peer companies (similar companies whose shares are traded on an exchange).

Comparable deals (assumed)

Deal: 1
Price, US$ per bbl of 2P: 14
After-tax cash flow, $/bbl: 17.5
Price to cash flow: 0.800

Deal: 2
Price, US$ per bbl of 2P: 16
After-tax cash flow, $/bbl: 20.0
Price to cash flow: 0.800

Deal: 3
Price, US$ per bbl of 2P: 12
After-tax cash flow, $/bbl: 16.0
Price to cash flow: 0.750

Deal: 4
Price, US$ per bbl of 2P: 21
After-tax cash flow, $/bbl: 24.0
Price to cash flow: 0.875

Deal	Price, US$ per bbl of 2P	After-tax cash flow, $/bbl	Price to cash flow
1	14	17.5	0.800
2	16	20.0	0.800
3	12	16.0	0.750
4	21	24.0	0.875

After-tax cash flow is the undiscounted cash flow (not brought back to today's money) per barrel of the reserves bought. For 2C contingent resources, such deals paid $2–3/bbl. EV/EBITDA of the listed peers: 2.8; 3.2; 3.6; 4.4; their reserves are enough for 8–12 years of production. The data are assumed.

Worked exampleThe same company by deals and multiples

Given (assumed data)

Deals and peers: the table above
Company: 2P reserves 10.4 million bbl, contingent resources 8 million bbl, licence C at cost, $3 million; overheads 15.3 million dollars (present value); net debt $55 million
EBITDA of next year: field A in year 4: revenue 120, royalty 12, operating costs 18 million dollars; overheads $3 million

Solution

Median price per barrel: $(14 + 16)/2 = 15.0$ dollars; the field $15.0\cdot10.4 = 156.0$ , the discovery $2.5\cdot8 = 20$ , the licence 3; equity $156.0 + 20 + 3 - 15.3 - 55 = 108.7$ million dollars.
The company's cash flow per barrel: $317.6/10.4 = 30.54$ $/bbl — noticeably more than for the comparables (16–24).
Adjustment for cash flow: the median price-to-cash-flow ratio is 0.8 (deals 1 and 2); the company's price per barrel is $0.8\cdot30.54 = 24.43$ dollars, the field $24.43\cdot10.4 = 254.1$ , equity $254.1 + 20 + 3 - 15.3 - 55 = 206.8$ million dollars.
EBITDA: $120 - 12 - 18 - 3 = 87$ million dollars; the median multiple $(3.2 + 3.6)/2 = 3.4$ ; $\mathrm{EV} = 3.4\cdot87 = 295.8$ , equity $295.8 - 55 = 240.8$ million dollars.
For comparison: the sum of the parts is 212.5 million dollars, the balance sheet 98.7 million dollars.

Answer: The median of the deals gives 108.7, the deals adjusted for cash flow 206.8, the EBITDA multiple 240.8, and the sum of the parts 212.5 million dollars.

What it means. The spread can be explained. The raw deal measure understates the value: the company's barrels are “faster” and cheaper to produce than the comparables' barrels, and each brings about 30.54 dollars against 16–24. The EBITDA multiple overstates it: year 4 is the production peak, and at this rate of production the reserves are enough for only 4.3 years, whereas the peers will go on earning for 8–12 years. After the adjustment for cash flow, the comparative approach differs from the sum of the parts by 3%. The data in this example are assumed for illustration.

CalculatedValuations of the equity of the example company by different methods, million dollars: the bars are ranges (the extreme deals and multiples; an oil price of $40–60/bbl for the flow of field A; a rate of 8–12%), the ticks are medians and base values, and the vertical line is the sum of the parts at $50/bbl and 10% (212.5 million dollars).

We do not average the methods. First we find out why they differ. Usually the reason lies in the assumptions: a different oil price on the date of the deals, a different reserves category, a peak year instead of an average one. For producing assets the income approach is usually the main one, and the comparative approach serves as a check. If the value from cash flow is much higher than all the deals, its price or production is most likely too optimistic. The oil price moves the sum of the parts much more than the rate does. At $40 or $60/bbl it changes by about 60 million dollars in either direction, and at a rate of 12% or 8% by only about 9. Here, only the flow of field A is recalculated for the price (the values of B and C would also change with the price). It is the price scenario that decides what a company is worth.

In this cross-check the book value is a reference item, not a guide to the price. It matters to the seller for reporting: a sale below the book value produces a loss in the seller's statements, and a sale above it produces a profit. It does not affect how much the buyer will pay.

Terms and symbols

Book value (carrying amount, net book value): The cost of creating or buying an asset minus the depreciation and impairment accumulated so far.
Unit-of-production depreciation (depletion): The cost of a field is written off in proportion to the share of its reserves produced in the year: $D_t = C_0\,q_t/R$ .
Successful efforts and full cost methods: Two ways of accounting for exploration costs: capitalise only the successful ones, or capitalise all of them. The cash flow does not depend on the choice.
Impairment and recoverable amount: Writing the book value down to the greater of two amounts: the selling price minus the costs of disposal, and the value in use.
Market value and fair value: The price at which an asset would change hands on the valuation date between informed parties, neither of whom is forced to deal.
Investment value: The value of an asset to a particular owner or buyer, taking account of its own taxes, synergies (benefits from combining the asset with its other assets) and rate.
Multiple: The price of an asset or a company divided by a measure of its size, such as reserves, production or EBITDA.
EV and EBITDA: EV is the value of a company to all the providers of capital ( $E + D - \mathrm{Cash}$ ). EBITDA is earnings before interest, taxes, depreciation and amortisation.
NAV: Net asset value: the sum of the values of the assets, each from its risk-adjusted cash flow, minus overheads and net debt.
Replacement cost: What it would cost today to create an object of the same usefulness, minus physical deterioration and functional and economic obsolescence.

Common mistakes and misconceptions

Wrong

“A company is worth as much as its equity on the balance sheet.”

In fact

The balance sheet shows costs not yet moved into expenses, and reserves in the ground are not shown in it at their worth. In the lesson's example the sum of the parts is $212 million against $99 million on the books.

Wrong

“Deals pay $15 a barrel, so our 10 million bbl are worth $150 million.”

In fact

First check the reserves category (1P, 2P, 2C), the cash flow per barrel, the life of the reserves, the tax regime, the share and rights of the operator, and the oil price on the date of the deal. In the lesson's example the adjustment for cash flow almost doubled the valuation.

Wrong

“Let us add the replacement cost of its pipeline and plant to the field's value from cash flow.”

In fact

The field's flow already contains the work of these facilities; their replacement cost is the same value counted a second time. Only what earns income independently of the field is valued separately.

Wrong

“An impairment of $23 million means the company lost $23 million this year.”

In fact

It is a recognition in the financial statements that money invested earlier will not be fully recovered. The cash flow of the year does not change because of it. The money was “lost” when the price or reserves outlook changed, not on the day of the entry.

Wrong

“A company using the full cost method has more assets and more profit, so it is more successful.”

In fact

The difference is only in the accounting. The company did not write off its dry holes at once but spread them over future production. The cash flows of two companies with identical wells are identical.

In depth: advanced detail

Unit-of-production depreciation when reserves are revised

Reserves are re-estimated every year. Past depreciation is not redone. Instead, the remaining book value at the start of the year is divided by the remaining reserves under the new estimate, so a revision changes only future years.

Unit-of-production depreciation after a revision of reserves

D_t = B_{t-1}\,\frac{q_t}{R^{\text{rem}}_{t}}

where:

$B_{t-1}$ book value at the start of year $t$ , US$ million
$q_t$ production in year $t$ , million bbl
$R^{\text{rem}}_{t}$ remaining reserves at the start of year $t$ under the latest estimate, million bbl

Units: any consistent units

Holds when

without revisions the formula coincides with $D_t = C_0\,q_t/R$ ; new investment is added to $B_{t-1}$ , and the reserves it opens up are added to the remaining reserves

Example: at the end of year 5 the unit-of-production book value of the field is 74.67 million dollars, and the remaining reserves are 5.6 million bbl. If the remaining reserves are re-estimated at 7.0 million bbl, the depreciation of year 6 at a production of 2.0 million bbl is $74.67\cdot2.0/7.0 = 21.33$ million dollars instead of 26.67: an addition to reserves stretches the write-off.

A company with no end date: terminal value

Companies in other industries are valued from the free cash flow for several years ahead, plus the terminal value. This is the value of all the later years, if the flow grows at a constant rate. In essence it is a growing perpetuity (a payment that goes on for ever and grows each year; how it is calculated):

Terminal value at constant growth

TV_n = \frac{FCF_{n+1}}{i - g}

where:

$TV_n$ value of the flows after year $n$ at the end of year $n$ , US$ million
$FCF_{n+1}$ free cash flow of the first year after the forecast period, US$ million
$i$ discount rate; for the flow of the whole company, the weighted average cost of capital (the average return that all its lenders and shareholders expect), fraction per year
$g$ constant growth rate of the flow, $g < i$ , fraction per year

Units: any consistent units

Holds when

the flow grows at a constant rate forever — the company keeps finding new opportunities that pay back the investment
the flow of each year arrives at its end; with mid-year flows, as in the examples of the lesson, the result is multiplied by $(1 + i)^{0.5}$

For an exploration and production company this assumption is doubtful. Every field depletes, and the flow does not grow by itself: it is sustained by new discoveries and acquisitions, which cost money. That is why such companies are more often valued as the sum of their parts (NAV). If the terminal value is used at all, it is checked against how many reserves would have to be found to justify it.

Why the share price does not equal NAV

The price scenario. The market may assume a different oil price from the analyst's. Value depends strongly on price (see the price bar on the lesson's chart), so this is the main reason for the differences.
Risk and overheads. Investors take account of risks that are hard to express in a cash flow, and of management costs that the sum of the parts may underestimate.
Future discoveries and deals. NAV does not include what the company has not yet found or bought. The market pays for the ability to find and buy profitably, or penalises the lack of it.
Liquidity and control. A controlling stake is worth more per share than a minority one. Shares that are hard to sell are worth less.

Connections to other topics

Net present value (NPV) — the NPV at the buyer's rate is the limit of the price that the buyer can pay.
Choosing the discount rate — which rate a buyer should use, and where the convention of 10% in reserves reporting comes from.
Cash flow model of an oil and gas project — what makes up the cash flow of the field being valued.
Project cash flow — why depreciation is not a cash flow and how profit differs from cash flow.
Annual capital charge — why accounting profitability rises with the age of the asset and does not equal the return.
Classification of reserves and resources — the categories of reserves and resources to which multiples refer.
Expected monetary value and preference theory — how exploration areas and discoveries are valued with probability taken into account.
Market, financial and regulatory uncertainty — the prices, exchange rates and taxes on which any valuation depends.
Oil companies and investment — what kinds of oil company there are and how they invest.

Check yourself

1
A field cost $240 million, and its reserves are 30 million bbl; 4 million bbl were produced in a year. What is the unit-of-production depreciation for the year?
1. A.$32 million
2. B.$24 million
3. C.$60 million
4. D.$34.3 million
Show the answer
Correct answer: A. $32 million
$D = 240\cdot4/30 = 32$ million dollars: $4/30$ of the reserves were produced in the year, and the same share of the cost is written off. 24 would come from straight-line write-off over 10 years, and 34.3 from write-off over 7 years. 60 would come from dividing the cost by the year's production.
2
A company drilled three exploration wells at $10 million each; one found a field and two were dry. By how much will its assets grow this year under the successful efforts method and under the full cost method?
1. A.By $30 million and by $10 million
2. B.By $10 million in both cases
3. C.By $30 million in both cases
4. D.By $10 million and by $30 million
Show the answer
Correct answer: D. By $10 million and by $30 million
Under the successful efforts method only the well that made the discovery is capitalised: $10 million. The dry ones are written off to the expenses of the year. Under the full cost method all $30 million is capitalised and then depreciated together with production. The cash flow is the same in both cases.
3
The book value of a field is $120 million. Its value in use is $95 million, and its fair value less costs of disposal is $105 million. What is the impairment loss?
1. A.$10 million
2. B.0
3. C.$15 million
4. D.$25 million
Show the answer
Correct answer: C. $15 million
The recoverable amount is the greater of the two amounts: $\max(105;\ 95) = 105$ million dollars. The loss is $120 - 105 = 15$ million dollars. 25 would result from comparing with the smaller amount, and 10 is the difference between the two estimates themselves.
4
A company's market capitalisation is $400 million, its debt is $150 million, its cash is $50 million, and its EBITDA is $125 million. What are EV and EV/EBITDA?
1. A.EV 500, multiple 4.0
2. B.EV 300, multiple 2.4
3. C.EV 600, multiple 4.8
4. D.EV 400, multiple 3.2
Show the answer
Correct answer: A. EV 500, multiple 4.0
$\mathrm{EV} = 400 + 150 - 50 = 500$ million dollars, and $500/125 = 4.0$ . 600 would result from adding cash instead of subtracting it, 400 from taking the capitalisation alone, and 300 from mixing up the signs of debt and cash.
5
Why is the book value of a good field at the start of production usually much lower than its value from cash flow, and why can it end up higher towards the end of its life?
Show the answer
The balance sheet shows development costs not yet moved into expenses, and the worth of the oil in the ground is not shown in it. At the start of production almost all the income lies ahead, while the balance sheet holds only costs, so the value from cash flow is higher. Towards the end of the life almost no income is left and abandonment lies ahead. If depreciation lagged behind depletion, or abandonment costs are underestimated, the book value will be higher than the worth, and the asset will have to be impaired.
6
A buyer valued a field at the median of comparable deals: $15 per barrel of 2P reserves. What needs to be checked before applying this measure?
Show the answer
Check the reserves category in the deals (1P, 2P, or including contingent resources), the cash flow per barrel after costs and taxes, the life of the reserves and the production profile, the tax regime and contract terms, the share and rights of the operator, and the oil price on the date of the deals. The more differences there are, the more adjustments are needed. In the lesson's example the adjustment for cash flow per barrel almost doubled the valuation and brought it close to the sum of the parts.

Updated: 26 October 2026