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Oil and Gas Equipment & Services

Oil and Gas Equipment & Services. Module 6: Cost of Capital and Valuation. Jeff Ritter. Agenda. Brief Review Module 4 & 5 Module 6: Cost of Captial and Valuation Cost of Equity Cost of Debt WACC. World’s Largest Oil F ield C ompany. Forecasting Performance.

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Oil and Gas Equipment & Services

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  1. Oil and Gas Equipment & Services Module 6: Cost of Capital and Valuation Jeff Ritter

  2. Agenda • Brief Review Module 4 & 5 • Module 6: Cost of Captial and Valuation • Cost of Equity • Cost of Debt • WACC

  3. World’s Largest Oil Field Company

  4. Forecasting Performance (Valuable opportunities may be lost) Multiple Method Theoretically based models for valuation • Integral to business decisions • Investing • Value a firm’s common stock before purchasing shares • Managing a firm effectively • Value different strategic investment decisions • Creditworthiness • Forecast the same information but choose to focus on the borrower’s cash flows. • Make best possible forecast NOT just conservatism

  5. Module 11 Module 4 Parsimonious forecasting Full informational forecasting Difference Level of detail used to form assumptions

  6. Factors considered in Sales Growth Estimate • Historical sales growth • Halliburton • Comparables • Analyst Expectations • High, Low, and consensus estimates: 2013, 2014, 2015 • Oil Rig Counts • Oil Prices and Demand • Earnings Call • “Mid to high single digit sales growth”

  7. Analyst Expectations for Halliburton

  8. Rig and Well Counts

  9. Sales Growth Assumption Historical growth for Halliburton and the Industry Rig and Well Count Ex: New construction Oil and Natural Gas Price & Supply/Demand Factors Historical growth has been inconsistent, but growth seems to relate closely to rig and well count. Oil prices and demand are expected to increase, but energy efficiency has slowed the consumption growth in countries such as China. Total rig count is on the decline dropping 10% in the US. 7.2% Includes GDP Growth 3% and inflation considerations 1.5%.

  10. Assumptions Sales Growth 7.2% EPM 9.4% EATO 1.56 *Calculating to the nth decimal place looks more professional but does not make the results more accurate.

  11. Issues with Forecast • We are external users: We only have access to general purpose financial statements that are given. • None of the companies are a “pure play” • May need to add additional comparables. • Look at additional information because sales growth is consistent in the industry, but the pattern needs further analysis. • Technip metrics are not consistent with the other firms (Eliminate)

  12. DCF Issues Module 5 Confidence LOW • Why? • Sales growth rate not based on full information • Continuous growth rate • WACC (Is it correct?) Increase in sales growth decreases enterprise value Determine growth rate for continuous value using additional data Determine if the Bloomberg WACC needs to be modified

  13. Module 6: Cost of Capital & Valuation Main consideration of Module 6 Can this 10% WACC assumption used in mod 5 be improved ? Yes ! Module 5 utilized ad hoc assumption of 10 % for the cost capital for the calculation

  14. Topic outline for Module Cost of equity Cost of Debt WACC

  15. Estimating the Cost of Capital These two costs are expected to be recovered by investors when they provide capital for use in the enterprise: The time value of money The compensation for taking the risk of investing in the enterprise operations. 1 2 Risk adjusted discount rate The return that investors require for investing in an asset.

  16. Cost of Capital Assumptions Current interest rates are a good approximation of expected (future) interest rates Current risk of the enterprise operations is a good approximation of the expected enterprise risk. These two assumptions can be changed in response to a change in riskiness. For Example, if a firm is entering into an acquisition that will result in a in a new line of business with a substantially different level of risk than current enterprise operations .

  17. Cost of Equity • Equity ownership is risky because it represents both risk of ownership of the enterprise and risk of needing to satisfy the obligations to debt holders as they fall due. Changes in the riskiness of the enterprise or changes in the cost of debt lead to changes in the riskiness of equity. • The risk of the enterprise operations in the Beauty or Health Care segments does not arise because the company has issued stock those segments • What do we estimate the weighted average cost of capital at? • An estimate of the cost of debt capital and an estimate of cost of equity capital

  18. Estimating the Cost of Equity • Use inputs of Beta, risk-free rate, and Market return • Beta must be calculated using historic returns • Risk Free rate must be observed using available resources • Return on the market must be estimated • Only Beta is Firm Specific • How is the cost of equity estimated? • The capital asset pricing model

  19. 1. What is the risk free rate? rf 3.6850% Use 30-year U.S. Treasury bills to determine this rate obtained from yahoo finance

  20. 2. What is the market risk premium? (rMkt – rf) Market Risk Premium 6% The market risk premium usually ranges 4 to 8%. Without additional information I’ll utilize 6% the median percent.

  21. 3. What is the Beta of Halliburton? • Beta is the the sensitivity of the asset's market return to the overall market. • In order to determine the appropriate Beta of Halliburton we follow the following process: • Perform a regression of the difference between the company’s stock returns and the risk free rate of return (the dependent variable) on the difference between the market index of returns and risk free rate of return ( independent variable). Performed over 60 months. • Research Halliburton’s Beta on commonly used financial websites • Bloomberg Beta estimate

  22. Key Stats:BetaR squaredConfidence Interval *Note: Did not subtract r(rf)—Bloomberg Method—small error possible • S&P 500 as independent variable and HAL as dependent Beta: 1.573 1.06-2.08 LOW CONFIDENCE • Beta = Coefficient of Correlation

  23. Beta: Financial Websites

  24. Bloomberg Beta

  25. Beta Average of all beta estimates 1.48 • What does the beta estimate mean? • When the market index moves by 1 percent Halliburton's stock return would be expected to move by 1.48%

  26. Cost of Equity using CAPM Calculation Cost of Equity r(rf) = 3.6850% Beta = 1.48 r(mkt)-r(rf) = 6% r(Eq) = 12.65% .03685 + 1.48 X .06 = .12565

  27. Cost of Debt Capital

  28. Cost of Enterprise Capital (.091 X 2,661,000/43,893,520) + (.12565 X (41,232,460/43,893,520) WACC 11.80%

  29. Choose Bloomberg WACC because of the established methodology My calculate WACC Bloomberg WACC WACC 11.80% WACC 11.50% Confidence Low

  30. DCF Analysis Using Bloomberg's WACC the Enterprise value is smaller than when originally calculated in module five because of the higher discount rate.

  31. Issues Main issue is the cost of debt I calculated is substantially different than Bloomberg's calculation Selecting the correct Beta Number Selecting the correct market premium amount

  32. Any Questions?

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