How the current market impacts the value of your energy business
How the current market impacts the value of your energy business
Companies in the energy sector are facing many challenges — from historically low natural gas prices to higher inflation driving up input costs. You may be wondering how all this volatility will impact the value of your company, and it is important to understand:
- How the current energy market impacts valuation
- When you would need a valuation
- What the valuation process involves
A valuation can help you understand what your company is truly worth. This can help you make informed decisions and navigate an uncertain industry from a position of strength.
Energy companies are facing numerous challenges — no matter whether your business operates in the field or provides services to other businesses in the industry. Commodity price fluctuations, historically low natural gas prices, and sustained high inflation in the face of high interest rates have had major impacts on capital costs, operating expenditures, and the cost of debt. How do these shifts in the market impact the value of your energy company?
Shareholders in public companies only have to look at the traded share price to know what their investment is worth — however, private company shareholders don’t have this luxury. A valuation can help you understand what your company is worth and what variables have the biggest impact on value without going through a sales process. This can help you make informed decisions and navigate an uncertain industry from a position of strength.
How does the current energy market impact valuation?
Energy companies are feeling the pervasive impact of an industry and economy in flux. Many businesses are excelling in the current market, from the producers and service companies working in the oilfields to the businesses that supply materials and equipment. However, this doesn’t mean they aren’t feeling squeezed — even while experiencing solid top-line results.
Higher inflation is driving up input costs and extended receivables are increasing the need for more working capital, especially for service providers. The highest bank rate since 2001 and the resulting higher lending costs are also causing a direct and noticeable impact to the bottom line.
So how does all this volatility and uncertainty impact the valuation of your energy company? Unfortunately, there is not a clear-cut answer that applies to every business — and there are multiple factors to consider.
The valuation of oil and gas production companies is driven by reserves, production, pricing forecasts, and the market. With major changes in price curves and how the market is pricing the various reserve classifications, relying on an outdated reserve report (which has become a moving target given current pricing volatility) will likely result in incorrect valuations.
Despite getting squeezed on margins, values for many companies in the services industry are on the rise — although perhaps not as much as one would expect. A higher cost of capital and forecast risk has somewhat tempered the upside. However, many companies are building up their backlog and/or locking in longer-term contracts to reduce risk and add to the company’s goodwill.
Why would I need a valuation?
There are many situations where it is important or desirable to know what a private company is worth, including:
- Transaction assessment
- You may receive an offer to sell all or part of your company. Is the offer reasonable? How are non-cash components of the offer assessed? These are some of the many questions a valuation advisor can help answer.
- Corporate tax planning
- Tax planning scenarios that would benefit from a valuation include rollovers, legal entity restructurings, and cross-border transactions. Because tax authorities like the CRA and IRS employ large teams of valuation professionals to audit tax-driven transactions, it is important to get the valuation component of the tax planning right.
- Management buy-outs (MBOs)
- Whether buying in or getting bought out, neither side of the deal wants to enter a transaction without some level of valuation certainty.
- Employee share ownership plans (ESOPs)
- ESOPs are used to provide incentives to employees. As such, for tax reporting and for accurate rewards allocation, fair market value determination is recommended.
- Shareholder disputes
- Disagreements between shareholders can often lead to buyout situations where fair market value of an interest in a company needs to be determined. Subject to the provisions of the unanimous shareholders’ agreement, the valuation professional will often have to address the complicated matter of determining the fair market value of a minority interest.
- Damages quantification
- If a company has been unjustly harmed, they may be subject to material financial losses including a loss of company value. Determining fair market value before and after an event can be a critical component in determining total damages.
- Succession planning
- It is highly recommended that the parties involved have an accurate understanding of fair market value when planning for the next generation or planning to use the maximum lifetime capital gains exemptions.
- Management tracking
- Your company’s growth goals may include increasing value. A valuation is useful to track progression and to help identify what is or isn’t working.
Valuations can include analyses that compare certain elements of your company’s performance to the performance of a set of guideline companies — elements such as profitability, levels of working capital, and growth. This can help you better understand your company’s strengths, weaknesses, and opportunities.
In other words, valuation advisors can help answer questions such as “How does my company stack up to the competition?” and “What should I focus on to improve my financial performance?”
It is important to keep in mind that while the market changes quickly, the value of your company may not change at the same rate. A regular valuation is a tool to help you determine how your company is progressing over time.
Valuations
How complex is a valuation?
For oil and gas producers with limited infrastructure, a valuation can be reasonably straightforward. In these cases, there tends to be limited goodwill and valuations are generally based on an asset valuation approach. Access to a reliable reserve report, current price curves, an estimate of the retirement obligations, and historical transaction multiples can further simplify the process.
Things get more complicated when there is goodwill, or value over and above the value of a company’s net tangible assets, which is indicative of well run and successful companies.
- Historical transaction multiples will vary considerably. How do you know what multiple to use?
- Where there are two similar companies and one has significantly more assets, the multiples will usually be materially different because asset-heavy companies tend to have lower risk.
- A company with long-term contracted revenues will often have a higher multiple that a company bidding on every job.
- A company operating across a wider geography with numerous customers may have a higher multiple than a company with geographical and customer concentration.
- A company with historically volatile EBITDA may have a lower multiple than a company with historically stable EBITDA.
Determining an accurate measurement of EBITDA and applying an appropriate multiple for your company will result in a supportable level of goodwill.
Getting maintainable or forecast EBITDA right
During a valuation, the valuator will review your income statement from the perspective of a notional purchaser. They will consider a number of adjustments — including whether the owner’s salaries are at market, if the owner is paying rent at market, or if there are any owner-related expenses that should be added back. These are called normalizations to earnings and are a critical step in presenting an accurate picture of a company’s historical and potential earnings.
Normalizations such as the adding back of owner-based expenses will increase historical EBITDA and could increase the value of your company. This process also allows for more transparency to a buyer if a sales process is being considered.
The multiple and implied goodwill
Determining the appropriate multiple is a complicated process involving the determination of your company’s cost of capital and, usually, a review of a number of guideline transactions and/or public company multiples, as appropriate.
An additional complication is understanding if the company’s implied goodwill, derived from the earnings times the multiple, is reasonable. Many business owners are aware that they have goodwill in their company, but most aren’t certain how to describe and define it.
Goodwill is usually a catch-all term for a company’s pure goodwill and all its intangible assets, including customer relationships, brand, technology and other intellectual property, and backlog. Additionally, not all goodwill is commercial — sometimes it relates to a particular person whose departure from the company could result in reduced financial performance.
An experienced valuator will define all the elements of goodwill and intangible assets to the best of their abilities to support the valuation conclusion.
Know what your business is worth
Changes in the energy industry can happen very quickly — however, the value of your company may not change at the same rate. A valuation can help you understand the factors that impact the worth of your business and may offer insights into its strengths and weaknesses. It is a useful tool to help you understand the true value of your business and navigate through the volatile energy market from a position of strength.
For more information, contact a member of MNP’s Valuations team. We can gather the data and deliver the insights to demonstrate the value of your business — for deals, exit plans, or disputes.
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