When it comes to the oil and gas industry, assets matter a lot. To be specific, there's nothing more important than reserves, rigs, submersibles, and refineries. However, to be truly valuable, these assets must be capable of generating profitable returns.
Value for money
Having assets is great, but without the ability to use them efficiently and profitably, they're essentially worthless. After all, it makes little sense for an exploration and production company to have a lot of acreage if it can't pull oil or gas from it. You have to understand how valuable assets are to the particular company that owns them.
To help evaluate this, we can look at some important metrics:
Return on assets, or net income divided by total assets, shows how much the company is earning compared to the assets it controls. The ratio is an indication of how effectively the company is converting the money it has invested in reserves, property, and other equipment into net earnings. The higher the value, the more profitable the assets are. The metric is pretty useful when used as a comparative measure -- against peers and the industry in general, too. A typical return on assets for the oil and gas exploration and production industry is about 6.2%.
Fixed-asset turnover ratio, or revenue divided by total fixed assets (such as plant, property, and equipment). Fixed assets form a major chunk of total assets for companies in this industry. This metric shows how efficiently the company is using its fixed assets to generate revenue. The higher the turnover rate, the better. For these companies, a value above 0.61 looks pretty good.
Total enterprise value divided by discounted future cash flows shows how expensive the company is when compared against its standardized future cash flows. The denominator indicates the total present value of estimated future cash inflows from proved reserves, less future development and production costs, discounted at 10% per annum. It's based on today's energy prices and doesn't give any credit for unproved reserves.
With these factors in mind, let's take a look at Chesapeake Energy (NYS: CHK) and see how it stacks up against its peers:
Return on Assets (TTM)
Fixed-Asset Turnover Ratio
Pioneer Natural Resources
Source: S&P Capital IQ; Company filings. TTM = trailing 12 months.
Chesapeake's assets don't seem to generate the best returns compared with some of its peers'. Additionally, at 4%, its ROA is less than the industry average. Its fixed-asset turnover isn't the best, either. However, keep in mind that these figures aren't bad at all.
The company's large reserves of natural gas in the Haynesville, Bossier, Marcellus, and Barnett shale plays make it the second-largest producer of natural gas in the U.S. However, given the lousy market for natural gas currently, the weak returns on assets aren't too surprising. Moreover, Chesapeake's current strategy is to shift toward higher liquids production, which has yet to see encouraging results. Capital expenditures are expected to be in the range of $7 billion to $7.5 billion in 2012, with 85% allocated to liquids production.
On the basis of future cash flows from proved reserves, the company looks quite cheap compared to its peers. I believe the stock could be undervalued.
Foolish bottom line
This isn't the only criterion you can use, although assets generally indicate how oil and gas companies have been faring in terms of operations. You can get a more comprehensive understanding by digging deeper. However, on the surface, Chesapeake Energy appears intriguing. We at The Motley Fool will help you stay up to speed on the top news and analysis on Chesapeake Energy. You can start by adding it to your watchlist.
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At the time thisarticle was published Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article.The Motley Fool owns shares of Devon Energy.Motley Fool newsletter serviceshave recommended buying shares of Chesapeake Energy and Devon Energy. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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