This Sky-High Valuation Might Be Warranted

Photo credit: Flickr/Nicholas A. Tonelli

Oil and gas producer Range Resources  sports an insanely high price-to-earnings ratio. How high? Try 90 times. But is it really that crazy?

By the company's calculations, production is likely to grow 20%-25% for the next several years. This will lead to a doubling of production every three to four years. CEO Jeff Ventura believes that cash flows will grow accordingly, depending on commodity pricing of course, and it could even outpace production growth. He even goes so far as to say, "Based on our cash flow multiple for our stock, then our stock price will double in three to four years, and then double again thereafter." Bottom line, he doesn't think the company's stock is cheap at all, because he's not looking at the P/E ratio.

America's energy boom has companies such as Range Resources and EOG Resources turning drilling rigs into money printing machines. However, this earnings power is hidden beneath nosebleed-level price-to-earnings ratios. That is why these companies are cheaper than most investors realize. This misperception is causing some investors to miss out on America's energy bonanza.

Take EOG Resources, for example. The oil and gas producer trades at a very rich 49 times earnings. However, energy company earnings can be masked by hedging losses or any number of one-time items. Investors can get a truer picture by drilling down into a company's cash flow. We find here find that EOG Resources trades at a mere 6.5 times its discretionary cash flow. No bleeding noses there.

The same can be said for Range Resources. This past quarter the company delivered generally accepted accounting principles earnings of $19 million, or just $0.12 per share. However, a deeper look reveals that the company delivered adjusted cash flow of $244 million. So far this year Range has produced $689.8 million of cash flow from operations. Conservatively, that puts the company on pace to produce $920 million of cash flow this year. With a market capitalization of $12.5 billion, Range Resources trades at about 13.5 times cash flow, which isn't all that expensive when we consider its growth potential. No wonder the CEO thinks its shares can double.  

Again, this is a company with line-of-sight production growth of 20%-25%. However, it sees cash flow growth outpacing production growth as long as commodity prices are steady. This is because the company's direct operating expense is down 15% on a per-unit basis year over year. Range expects to continue to drive efficiencies in the future, with further upside to its cash flows if natural gas prices move higher. Bottom line, Range Resources isn't as expensive as it might seem at first glance, and even if it were, it could easily grow into its valuation.

The same can be said for Cabot Oil & Gas . Like EOG Resources, it trades with a price-to-earnings ratio in the upper 40s. However, this is a company that expects to grow natural gas production by 44%-54% this year and by as much as 50% next year. It has a 25-year drilling inventory at current drilling levels. Clearly, Cabot Oil & Gas has a lot of growth ahead.  

This isn't to say investors should just pick the most expensive energy stock they can find. That's because not all companies are seeing the economics at current prices to grow as fast or as profitably as Cabot or Range. Ultra Petroleum , for example, had to cut its growth rate because the returns just aren't there. This year the company is spending $415 million in capital, or about half of what it spent in 2012. That's all it can afford given its current cash flow. This is because Ultra's rates of return in the Marcellus can range from 19%-88% depending on cost and reserve size. Range Resources and Cabot Oil & Gas, on the other hand, are seeing triple-digit returns. While Ultra has a big upside if gas prices improve, Cabot or Range have that same upside even if prices stay low.

Investor takeaway
It's important to look closely when considering an oil and gas investment. These companies tend to appear overvalued at first glance, but a deeper look can reveal an inexpensive stock. That's especially true when considering how much growth these companies can expect to deliver by tapping into America's shale boom.

Invest in America's energy boom
Range Resources is fueling helping fuel record natural gas production that is revolutionizing the United States' energy position. The company has tremendous growth and it could pad your portfolio with wealth for years to come. However, The Motley Fool has uncovered three energy companies we like even better. To get those names (hint: one was mentioned in this article), check out the special free report, "3 Stocks for the American Energy Bonanza." Don't miss out on this timely opportunity; click here to access your report -- it's absolutely free. 

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Fool contributor Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Range Resources and Ultra Petroleum, owns shares of EOG Resources and Ultra Petroleum, and has options on Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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