EOG Resources (EOG +0.67%) is just printing money these days. Unfortunately, some investors are missing out on investing in the company because they are looking at the wrong number when looking at EOG's stock. To some investors a triple digit stock price and a price-to-earnings ratio north of 45 is just too expensive to consider. The problem with those numbers is that neither is a good way to gauge the value of an energy company.
Drilling down past the P/E ratio
Oil and gas accounting can really mask the true performance of an energy company. So, to use a traditional valuation metric such as the price-to-earnings could cause investors to miss out on a great company. First of all, P/E ratios are backward looking, meaning that if something depressed earnings or even inflated them it could skew the numbers. Not only that, but energy company earnings can be affected by hedging gains or losses among other things.
For example, Bakken focused Kodiak Oil & Gas (NYSE: KOG) turned in earnings of just $0.17 per share last quarter. This was half of what it reported in the year ago quarter. Unrealized gains from hedging its oil and gas caused a huge swing both quarters, however, leveled out that company actually grew its earnings 20% year-over-year. More importantly, the company's underlying cash flow more than doubled, however that growth was masked by relying on its P/E ratio.
A closer look at the numbers
It's the same story at EOG Resources. While it reported net income of just $2.44 per share, the true cash generation of the business is masked. For example, reported net income was $659.7 million yet its discretionary cash flow clocked in at $1.87 billion. That's up 35% over the same quarter of last year. Through the first six months of this year EOG has produced $3.5 billion of discretionary cash flow, which if projected out over the full year suggests the company is trading at just 6.5 times its discretionary cash flow. That's certainly not the nosebleed valuation that appeared at first glance.
A similar way to look at valuing EOG's stock is to look at its enterprise value to EBITDA ratio. Here is a great slide from Occidental Petroleum (OXY +1.04%) that really puts this into perspective.
Source: Occidental Petroleum Investor Presentation (link opens a PDF)
Notice when looking at this ratio that EOG stacks up right in line with its larger rivals like Occidental or Devon Energy (DVN +0.72%). It's not dirt cheap and it shouldn't be because the other factor to consider is its growth, and this is where EOG really shines.
Oil fueled growth
EOG is expected to deliver best-in-class crude oil growth through 2017. This year the company is expected to grow its oil production by 35%, which is the minimum rate it has delivered since 2010. That's well above Devon for example which is expected to grow its oil production by 16%-19% this year and Occidental which will only grow its oil production by 8% this year. With investors putting such a premium on companies that can grow oil production these days, this is an important consideration.
Put another way, best-in-class oil production growth really does deserve a higher-valued stock. So, with EOG trading basically in line with its peers it could be argued that its stock is actually pretty cheap on a relative basis.
Investor takeaway
It's important for investors to drill down a little deeper when looking to buy an oil and gas stock. Looking solely at the P/E ratio could cause investors to miss out on a great stock like EOG Resources. That's because a closer look shows that its stock is a lot cheaper than it would first appear.
Drill down even deeper into EOG resources
