Monday, January 7, 2013

Review of Theoretical Price in the Oil and Gas Sector

We are interested in securities trading at a discount relative to the theoretical price generated by Ohlson's Clean Surplus Theory.  You'll notice that most of them are trading at a premium.  This could mean that the entire sector is over-valued, in which case it would be imprudent to make a purchase at all.  We'll look more carefully at that in a later post.

As I mentioned previously, you have to use a bit of common sense when you interpret the results using financial analysis software.

Let's look at PSTR (Post Rock Energy Corporation) for example.  You can see it is trading at a 100% discount to the theoretical price.  Does that make sense?

The future theoretical book value grows rapidly because of its very high return on equity rate.  You'll notice that the ROE is significantly higher than every other security; at 256%, it seems rather fishy.  It is high in part because preferred shares reduce the denominator but there is no preferred dividends reducing the net income in the numerator.  Most preferred shares are cumulative, so I researched the financial statements at source.  They are cumulative and have been declared and paid.  Therefore, the numerator is incorrect.  Upon further research, I realize the denominator is incorrect as well. When preferred shares are subtracted from shareholders equity, the value is negative.  Therefore we do not have a meaningful ROE; without which we cannot calculate the clean surplus.

So the very high, uncharacteristic ROE alerted us to a problem.  If we had just jumped on this security as being undervalued without evaluating whether it makes sense, we would have made an error.

There are three other securities trading at an apparent discount: PZE, STO, and VOC.

PZE has a reasonable cost of equity, a reasonable ROE.  However, I noticed that Net Income After Tax was positive, but the EPS was negative.  I investigated the financials in Google and noted that NI after tax was positive, but NI was negative.  Normally that would be the result of a low persistence item like an accounting change or discontinued operations or an extraordinary result, but the financials in google were non-illuminating.  I tried to pull it up on the company's website but it is an Argentinian company and the website was in Spanish.  I was able to find the quarterly results but not the annual ones.  I also tried the SEC and but I had no luck.

Just for fun, I added another column for net income on the data sheet and recalculated ROE using that number.  ROE becomes -8% and the discount becomes a premium (75%).

It's my opinion that Net Income After Tax is the right line item to use in this calculation because we want to get close to the true, actual operating results.  We want to remove superfluous transactions or events that won't repeat.  (Just as an aside, frequently it is just the transactions that have a negative effect on the income statement that are pulled out to go below the Net Income After Tax number.  This is unfortunate as it hints toward earnings manipulation and ultimately degrades the capital system.)  I feel a little uneasy about PZE because I can't get to the bottom of the discrepency   So, I'm going to be cautious.

After reviewing STO, nothing jumped out at me as being cause for concern.

I did notice that VOC is a very small company - it's market cap is only $243 Million and that I don't have a beta for it.  Therefore the clean surplus calculation is incorrect...we have to take VOC off the list.

So we have as candidates STO, and cautiously PZE.

Next post we'll start putting all the financial analyses together.

Thanks for reading.

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