One of the most challenging things in investing is figuring out how to value a company. In the energy industry, exploration and production companies own lucrative assets with the potential to generate oil and natural gas for decades into the future, and with so many variables to consider, it can be daunting to come up with models that can accurately guide a valuation estimate. However, the PV10 concept is designed to simplify valuation for energy companies, and it's an important metric that every investor in the energy sector should understand and consider in making investment decisions.

What PV10 is

The basic gist of the PV10 method of valuation will be familiar to anyone who has used any sort of discount valuation model. PV10 seeks to determine the present value of an energy company's current oil and gas reserves. To do so, you start by taking production estimates on a year-by-year basis and multiplying them by the expected market price for oil and gas in that year. Then, subtract the costs of production to bring those reserves out of the ground and ship them to market. That will give you a timeline for how much profit the company expects for each year in the future.

Oil rig.

Image source: Getty Images.

Where PV10 gets its name is that you then discount the figures in future years at a rate of 10% per year. So if the figure for next year is $100 million, then you'll discount it by 10% and get a present value of $90 million. Add up the present value figures for as many years as your current reserves will produce, and the total gives you the PV10 figure.

Typically, PV10 calculations only incorporate what are known as proved reserves. Because of the more uncertain nature of what energy companies claim as probable reserves and possible reserves, the quick PV10 method generally doesn't take them into account.

Why PV10 matters

Oil and gas investors use PV10 as a proxy for the true value of a company's reserves, and therefore, comparing the market value of shares of an energy company with the PV10 value offers a quick reading on whether the stock is overvalued or undervalued. One key to understanding PV10 is that you should compare it to enterprise value rather than market capitalization, because outstanding debt is often a major item on balance sheets within the energy sector.

In addition to using PV10 as an absolute valuation metric, you can also use the number to compare valuations across different companies in the oil and gas industry. If one company's ratio of its enterprise value to PV10 is higher than another's, then one might conclude that the second company is a more attractive value for potential investors than the first.

Finally, PV10 can be a good way to judge asset acquisitions. If a company pays less to acquire oil and gas properties than its PV10 value, then one can judge that the company made a good deal. Conversely, paying above PV10 suggests either an overpriced market or a judgment from the purchaser that the prospects for the asset are better than the current forecasts.

The big problem with PV10

The largest challenge in using PV10 is that you have to make dramatic assumptions to come up with the numbers that go into the model. Proved reserves are available on corporate balance sheets, but how much production comes from those reserves on a year-by-year basis can vary greatly. Moreover, although you can use oil and natural gas futures contracts to predict the future direction of energy prices, the reality can differ greatly from those estimates, and few energy companies actually lock in those futures prices for a large portion of their future production.

Nevertheless, market participants in the energy industry look at PV10 all the time. They understand its shortcomings, but they still appreciate the information the metric gives them.

If you want to be a better energy investor, understanding PV10 and why it's important is a first step toward broadening your knowledge base. That way, you won't be in the dark when your investor peers use PV10 as the basis for their investing thesis for a particular oil and gas exploration and production company.