In this clip from the Industry Focus: Energy podcast, Sean O'Reilly and Taylor Muckerman talk about why PV-10 is one of the most important metrics investors should examine before investing in an upstream oil company. To put it simply, it's an estimate of the current value of a driller's proven oil and gas reserves, but, by necessity, there's a lot of guesswork involved in that calculation. The question for potential investors: Is a company is undervalued based on their PV-10?
A transcript follows the video.
This podcast was recorded on July 28, 2016.
Sean O'Reilly: I'm an oil company, Sean Oil. Someday. I've spent a bunch of money on exploration development costs. I go out and I drill these wells, which is production costs. The byproduct, of course, are reserves, and these are measured on the balance sheet of these oil companies, or in this case, Sean Co., as PV-10. What the heck is PV-10?
Taylor Muckerman: PV-10 is, if you've been in finance for a little while or you're just new, it's basically discounted cash flows that you expect to receive from this oil. So you take your reserves, minus the cost that you expect to have to outlay to extract those reserves, and then discount it by 10% back to the present value.
O'Reilly: The reason I asked you that and what I wanted to impress upon our listeners is it involves a lot of guesswork.
Muckerman: Yes, it does. Yeah.
O'Reilly: They have to do it. It belongs on the balance sheet.
Muckerman: It's basically just a way to kind of create a standard across the industry, because you've got these oil reserves that have varying levels of degree of certainty that they can be extracted. You look at what they call the three Ps: proved, probable and possible. Proved is we got 90% certainty. Probable is 50% certainty, and possible is 10% certainty. When you're looking at PV-10, that's generally only proved.
O'Reilly: From what I've seen, most companies only talk about the first two, right?
Muckerman: 10% certainty, that's not really much to hang your hat on. Sometimes you look at a junior company, they want to talk about that because they want to show these big boys, hey, you've got the technology to probably increase the likelihood of this, so maybe you can buy us. Then they become probable, or they become proved for you. For us, that oil's probably never coming out of the ground, but we own it so if you want it, come buy is.
O'Reilly: Got it. OK.
Muckerman: Then you can use that number ... You put enterprise value over that so you can get an idea of [valuation]. If the enterprise value is less than the PV-10, that company is most likely undervalued based on what they hold in the ground.
Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.