The Effect of Margin and Reserves/Production Ratio on Oil and Gas Transaction Multiples

Abstract Precedent transaction multiples are often used to estimate the market value of oil and gas assets. The multiples typically used for valuation include production, reserves, and cash flow multiples. Improper application of these multiples can lead to valuation estimates that are significantly different than actual market value. This paper outlines a method to improve the accuracy of market value estimates from multiples analysis by incorporating (1) the correlation between multiples and proved reserves to production ("R/P") ratio, and (2) the effect of profit margin ("margin") on transaction multiples. The effect of margin is especially relevant because some transaction metrics are not necessarily valid in the current market due to significant changes in commodity prices. Economic runs for a variety of conditions were made to observe the theoretical effect of R/P ratio, margin, and discount rate on net present value. The net present value at a 10% discount factor ("PV10") was used as a proxy for market value. Then, production, reserves, and cash flow multiples were calculated and analyzed. Relationships between the different variables were studied, and equations to calculate the various multiples as a function of R/P, margin, and discount rate were constructed. Comparison of multiples generated from discounted cash flow ("DCF") regression analysis to actual transaction data show that the shapes of the various curves generated agree with the historical trends. This paper also includes commentary on how to correctly apply the multiples to asset valuation, equations to calculate the various multiples, and a discussion of pitfalls to avoid when performing multiples analysis.