Who’s a major? A novel approach to peer group selection: Empirical evidence from oil and gas companies

Abstract

This study presents a novel approach to selecting comparable companies in equity valuation. While valuation multiples is probably the most common valuation method in practice, discounted cash flow and residual income valuation models are advocated by academics. A key aspect in valuation by multiples is peer group selection. In this paper, we examine the usefulness of econometric techniques in peer-group selection for the largest companies in the international oil and gas sector. Using Chow tests, we are able to identify firms with similar relationships between valuation multiples and relevant value drivers. These results of our study suggest that analysts and investors should, when carrying out valuations, be careful in selecting the companies that comprise the peer groups. Comparable company selection could be carried out using econometric techniques that select companies on the basis of similarities in the relation between financial information and market valuation, instead of being based purely on analysts’ subjective judgments.

Keywords:

• oil and gas companies
• oil majors
• valuation
• valuation multiples
• peer groups
• p/e
• Exxon

Public Interest Statement

Equity valuation is one of the most important applications of finance theory. Survey studies suggest that valuation by multiples is undoubtedly one of the most common methods of equity valuation in practice. Valuation multiples are used to determine share price estimates, as well as for the valuation of initial public offerings, investment bankers’ fairness opinions, leveraged buyout transactions, seasoned equity offerings and other merger and acquisition activities. A crucial element of multiples valuation is the selection of an appropriate peer group. Typically, the financial analyst would select peer companies on the basis of subjective judgements. This approach to peer group selection might not be optimal. We propose an alternative approach using econometric analysis. The purpose of our method is to select peer group companies on the basis of the relationship between fundamental information and market valuation. The oil and gas sector is used as a case study.

Acknowledgements

The authors are grateful to IHS Herold for providing the data for our research. We would also like to thank the participants at the 9th IAEE European Energy Conference in Florence, Italy, for useful comments to our paper.

Notes

1. As defined by IHS Herold (www.ihs.com/herold).

2. This refers to choice that oil and gas companies, reporting financial statements according to either U.S. standards (Financial Accounting Standards Board, 2009, 2010) or international standards (International Accounting Standards Board (IASB), 2004), have to choose between two competing accounting methods for pre-discovery exploration activities. Under the full cost regime, all exploration costs are capitalised, while under the alternative method, successful efforts, only costs accrued from the exploration of producible wells are allowed to be put on the balance sheets.

3. JS Herold Inc. supplies accounting and operational data from 500 companies (public and privately owned). The company website is located at www.ihs.com/herold.

4. See Financial Accounting Standards Board (2009) and Securities and Exchange Commission (SEC) (2008) for a description of current oil and gas disclosure rules.

Additional information

Notes on contributors

Frank Asche

Bård Misund holds a PhD from the University of Stavanger. His research interests cover topics on commodity markets and firms, including commodity price behaviour, the spot–forward relationship in futures markets, determinants of commodity firm stock returns, financial statement analysis and valuation of oil and gas firms. Professor Misund has published articles in international journals in accounting, finance and economics. Misund has more than 10 years of industry experience.

Bård Misund

Frank Asche holds a PhD from the Norwegian School of Economics and Business Administration (1996). His research interests focus on aquaculture and seafood markets, but he has also been doing work in fisheries management and energy economics. Professor Asche has published numerous articles in international journals in economics and leading multidisciplinary journals like Science and PLoS One. He has also undertaken a number of research projects in Norway as well as for international organisations like the FAO, OECD and WTO.