The Intrinsic Valuation of Global Oil Stock Prices: Graham Number Technique

Abstract

This study utilizes the Graham Number approach to determine the intrinsic valuation of global oil stock prices in 11 major stock markets. There were 178 listed international oil companies (IOCs) identified in this study. Using IOC’s market capital, their last year earnings per share (EPS), the price equity ratio (PE), book value per share (BVPS) and the latest stock price recorded last September 29, 2016, the study computed each intrinsic value (EPS x (8.5 + 2g) x 4.4 / Y). The result shows that 85 or 45% are undervalued and 93 or 52% are overvalued. The Chi square, X2 (2, N = 178) = 0.00067, p <.01, demonstrate that stock markets located in areas with major oil and gas industries ( Australia, Argentina and Vancouver) are likely to show overvalued oil stock prices.

Introduction

One of the most dominant branches in the global economy is the oil industry, which annually, produces four billion metric tons. The Middle East accounts for a third of the world production, while Russia and Saudi Arabia are recognized as the world top oil producers, each contribute 13 percent in the total global production. Meanwhile, the US, is the third-largest oil producer, contributing 12 percent in the global oil production (Beyazay, 2015)

In 2016, the US Energy Information Administration (EIA) reported that the global petroleum and other liquid fuel inventory build will average, 900,000 barrel per day, a slowdown from 1.9 million b/d in 2015. In 2017, the market average inventory balance is predicted to reach, 3000,000 b/d. However, global oil consumption will increase 1.4 million b/d in 2016 and 1.5 billion b/d in 2017. The increase demands are from the countries outside the Organization for Economic Cooperation and Development (OECD). The non OECD countries projected oil consumption is at 1.3 billion b/d in 2016 and 1.5 billion b/d in 2017. The increase is attributed to the increase use of transportation fuel in India, while China’s oil consumption is forecast to grow 400,000 b/d both in 2016 and 2017 (OGJ Editors, 2016)

International oil companies (IOCs) are recognized among the world’s largest businesses. The ten biggest revenue earning companies, six are IOC. In 2015, the Royal Dutch Shell, the world’s seventh largest IOC, reported revenue at almost $265 billion. Exxon Mobil, the eight largest IOC, reported earnings at US260 billion (Gallucci, 2015).

Rising steadily, over the last decades is oil demand and consumption (Jaffe, 2016). The US remains as the world top oil importer and consumer. However, since 2005, US oil importation has been in the constant decline. On the other hand, China, reported a rapid increase in oil consumption in recent years (Hydrocarbons, 2013).

Over the years, fluctuating oil prices brought an extensive global consequence on economic growth and political stability (Taghizadeh-Hesary & Yoshino, 2015). Natural gas is turning into an affordable and clean energy source (IGS, 2016). Similarly, IOCs are increasing the lead in the offshore oil exploration and production. IOCs have successfully integrates and envelops all natural gas value chain elements.

Majority of IOCs are publicly-traded. Given the huge market capitalization required, they impact their host country’s economy. IOCs stockownership is an attractive investment and investors are interested to access reliable information as to their stock value. The previous mergers and acquisition that changes the oil industry landscape adds more attention to their true stock value.

Stockowners resort to several valuation methods to determine public-listed IOCs. Individuals and portfolio managers today used different valuation methods. Among this was formulated 60 years ago called the Graham number (Milosevic, 2016). This was formulated as an intrinsic value which is justified by the IOCs assets, earning and dividends. The Graham number prevents investors from the wrong judgement they are vulnerable to during market periods of deep pessimism or high optimism (Sainio, 2016).

This study focuses on the oil industry’s intrinsic value in the major global stock exchange market using the Graham number. There are 11 stock markets involved in the study: Athens Stock Exchange (ASE); Australian Security Exchange (AUX); Buenos Aires Stock Exchange (BUE); Hong Kong Stock Exchange (HKG); London Stock Exchange (LSE); New Crest Mining Limited (NCM); NASDAQ; New York Stock (NYQ) Pink Sheet (PNK); Toronto Stock Exchange (TOR); Vancouver Stock Exchange (VAN). The intrinsic value refers to the oil stock fundamental value. There are analysts which claim that the oil stock value is higher than the current price (Crowe, 2016). They are anticipating the oil rebound, predicting an increase in oil stocks value in the future (Slav, 2016). IOC’s have the more volatile life cycle. The oil drilling activities have a tendency to compensate for higher risk through extremely high returns. Even with the latest drilling technologies, IOCs face high risk outside their control, including commodity prices and regulations. There are circumstances that the IOCs intrinsic value exceeds market value (Zillman, 2016).

Framework

This study is based on the seminal works of Benjamin Graham, to find stocks that in the long-term, will do much better than the market. Graham identified two problems for investors. First, there are stocks which demonstrate growth prospect, but does not necessarily turn into profits. Second, investors might be wrong about the company’s growth prospect. In other words, investors are misled through the market over optimism which tends to overvalue or undervalue stocks. In the end, investors can only expect an average return. However, due to misjudgement, investors added risk of underperformance. In order to circumvent an average return in investment, Graham proposed a method to reduce risk through determining the stock intrinsic value independent of the market (Graham & Dodd, 1934).

Method

The data used in this study are from the 178 IOCs listed from 11 stock markets. The data used are the IOCs, market capital, their last year earnings per share (EPS), the price equity ratio (PE), the book value per share (BVPS) and the latest stock price recorded last September 29, 2016 (Khan, 2015).

The study performs two types of analyses. First, Graham Number a technique used to measure the IOCs stocks’ fundamental values through their EPS and BVPS. It is a general test used to identify if oil stocks are presently selling for a good price. A stock price less than the Graham number is overvalued and greater than is undervalued (Graham, 2009). Second, is the Chi-square test for homogeneity, a non-parametric statistical technique used to determine whether the 11 stock markets and the IOCs intrinsic value are dependent at .01 level of significance.

Benjamin Graham in his 1959 book “The Intelligent Investor,” presented the formula for the intrinsic value as (Graham, 1959)

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The earnings per share (EPS) which served as the IOCs profit measure was for the last year. The IOCs projected seven to 10 years; growth rate is g. Graham used the 8.5 multiplier for the price equity ratio, to describe an IOC with no growth. The intrinsic value and current stock price quotient s used to evaluate the oil stock price. If the number is less than 1, the stock is not a good buy. The formula assumed the economy at low inflation and growth real and tangible with Y is the yield for a 20-year AAA corporate bond interest at the 4.4% desired rate of return (Serenity, 2016).

The Graham number has its weaknesses. The formula only utilizes EPS to evaluate the IOCs and does not include the non-operating liabilities (GuruFocus, 2012). Admittedly, creative accounting methods can manipulate the EPS. Ideally, normalized EPS should be calculated from 10-year history. Graham (2009), himself, identified the formula limitations, advising to use the model in financially strong companies with above-par debt position. It was suggested that Graham number was to be used for companies with not less than 60% total asset ratio; EP ratio twice the corporate AAA bond yield and EPS less than the net working capital per share (Perritt)

Results and Discussions

Table 1 shows that the following stock markets have more overvalued oil stock prices: Australian Stock Exchange (5, 3); Buenos Aires Stock Exchange (1, 0); New Crest Mining (4, 0), Pink Sheets (4, 1) and Vancouver Stock Exchange (6, 0). On the other hand, the following stock markets have more undervalued oil stock price: Athens Stock Exchange (3, 4); Hong Kong Stock Exchange (1, 2), London Stock Exchange (1, 14) and Toronto Stock Exchange (10, 21). While, the New York Stock Exchange has an equal number of under and overvalued oil stocks (48, 48). In all there are 85 or 48% stocks, overvalued and 93 or 52% undervalued.

Table 1. Frequency and Percentage distributions of the over and undervalued stock markets

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Noticeably, stock markets located in places with huge oil and gas industries tend to have more overvalued stocks compared with the stock markets located in other places. Australia, one of the only three members of OECD exports liquefied natural gas (LNG). Among the OECD, Australia is a net exporter of gas and the biggest exporter of coal (AMMA, 2016). Their oil, gas and energy industry is recognized as the biggest contributor in their GDP, $6.2 billion generated value, annually. There is an increasing heavy investment in the oil, gas and coal exploration and development in the country. In the near future, experts believed that Australia will be a very competitive in that sector. In recent years, the country demonstrates their oil, gas and energy sector as a reliable player. Forecast in the immediate future remains to show a strong growth potential capable of expanding production and increasing exports (Murphy, 2014).

The huge shale oil and gas reserves discovered in Argentina in the early 2000s brought hope to their rather complex economic scenario. The world-class shale discovered in Argentina attracted huge private investors (Vasquez, 2016). According to the Energy Information Agency (EIA), Argentina ranks third among countries holding nonconventional gas reserves and fourth in shale oil. Still early in the exploration stage, Argentina poses to be a major player in American shale oil industry (S&P Global Platts, 2016).

Although global oil prices have dropped significantly, experts do not expect it to have any influence on Argentina’s long-term investment plan which includes the exploration of the country’s nonconventional oil (S&P Global Platts, 2016). The oil short-time price fluctuations do not have any effect on several big projects for the next 35 years at Vaca Muerta. At the end of 2015, YPF and Cheveron were the first to venture into production at Vaca Muerta, extracting 54,000 barrels per day which was part of their $16 billion long-term project. In early 2016, YPF and Dow Chemical began their $2.5 billion shale gas project at the same time Exxon Mobil launched a $14 billion shale project. Petronas, Shell and Total are soon to follow with their projects (Vasquez, 2016).

In Canada, BC is the second largest natural gas producer in Canada. The British Columbia (BC) Oil and Gas Commission, is expecting an increase in natural gas demand and proposed liquefied natural gas (LPG) projects. They developed a forecast for the LNG market demand. The forecast scenario was based on five new LNG plant operational capacities to export 82 megatons by 2020. The oil industry paid $1 billion in the domestic economy and in 2015 spends $3.5 billion in exploration and development. Canada’s LNG export facilities developments remain to be its top priority (CAAP, 2016).

Oil stock market investors always endeavour to discriminate between the under and overvalued stocks relative to its price in the market. For this reason, Graham strongly recommend that aggressive oil stock market investors have to search for the IOCs earning stability over the past decade, taking note of their positive or negative earnings. The IOCs must demonstrate sufficient financial size and capability that would allow the company to withstand any immediate set back especially during the volatile period. Investors can also discover bargains in secondary IOCs. These are companies with smaller concern in the oil industry (Towson, 2011).

Graham noted that the stock market tends to undervalue these oil firms. At the same time, these oil firms can withstand the different economic environment with the ability to provide return on investment. During the bull market, these undervalued oil firms’ advances to full valuation (Arnold, 2012).

Evidently, investors create an understanding of the business and economic condition enough for them to form their own opinion and the prospect of an oil firm. However, subjective factors tend to mislead investors. It is preferable for investors to base the decision on quantitative factors. Graham noted that investor’s decision “should be based not on optimistic but arithmetic,” (Brandes, 2015)

A chi-square test of independence in the Table 2 was performed to examine the relation between over and undervalued oil stock prices and stock markets. The relation between these variables was significant, X2 (2, N = 178) = 0.00067, p <.01. Stock markets located in areas with huge oil and gas industries are likely to show overvalued oil stock prices than those stock markets with an absence of a major oil industries.

In 2015, oil and gas companies’ stock prices continuously drop creating different financial scenarios. It will take several financially affected oil companies years to recover and even some stable companies are for sale at a huge discount. Surprisingly, there are number of oil companies notwithstanding the industry decline in share prices remain to be overvalued in the middle of the down market (Crowe, 2015).

Table 2

Frequencies of over & undervalued stock markets

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Experts suggest that some oil company’s overvalued equity arises from over investing in oil exploration. In the latest count, seven out of 100 most valuable quickly trade firms were oil and gas companies. The global oil industry’s combined market capitalization is more than $1.3 trillion. However, many large oil companies are state owned, the estimated current oil industry sector, the true valuation could reach $4 trillion (Martin & Kemper, 2015).

The greatest portion of overvaluation arises from the oil companies’ reserves account on the balance sheet. To continue its increase, oil executives are willing to invest aggressively in finding more reserves because if they stop investing on new exploration, investors will interpret that the oil companies’ current reserves do not worth as much. It is not clear on the degree of effect in oil stock value if the oil companies express that they will end their exploration. However, the analyst concluded that the stock value decrease would be catastrophic. The overvalued oil equity trap creates economic as well as a social problem (Martin & Kemper, 2015).

ConclusionS

Generally, almost half of global oil stock prices are overvalued. Most of these overvalued stocks are in AUX, BUE, NCM, NMS, NYQ, PNK and VAN stock markets. Stock markets located in areas with huge oil and gas industries are likely to show overvalued oil stock prices. Learning from Graham, investors should control their purchases to oil stocks selling not far above their value, while a better margin of safety to investors are stocks selling below their intrinsic value.

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