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Intrinsic Valuation

In this paper I will first discuss the components that make up the discount rate and calculate EOGs cost of equity and WACC. Following that, I will use a FCFF model to value EOG and then use a simulation model to help develop Best/Worst case share prices.

Discount Rate
The value of an asset is the sum of its discounted future cash flows. These cash flows must be discounted in order to account for variability (risk) in their final value. The discount rate used should represent the risk inherent in these cash flows. The following equation describes the components of the discount rate: ( ) Where: E(R) = expected return of security Rf = Risk-free Rate Beta ERP = equity risk premium In the following sections, we will discuss the Risk-free rate, Beta, and the Equity Risk Premium. Each of these components will also be estimated in order to calculate EOGs discount rate. Risk-free Rate The risk-free (RF) rate of return is the foundation that all expected return models is built around. Its a generally accepted principle that bonds issued by governments in developed countries are indeed riskfree. The maturity of the bond chose to represent the RF rate of return should match the time horizon of the cash flows we are valuing. This implies that the proper RF rate is that of a long-term government bond. The recent financial crisis has caused the rates of all government bonds to fall substantially. US 10-year rates fell to a low of 1.43% during the summer of 2012. This has caused many to turn to using a normalized RF rate in their valuations, but is this the right thing to do? I dont believe so. What is the correct normalized interest rate to use? What is normal is a completely personal thing. While a 4% interest rate may seem like the logical RF rate, others may believe it should be 5%, 7%, or even 12%. Normalized rates reflect the time period they were calculated from. The matter of selecting the correct time period to average is completely subjective with no clear right or wrong answer. Using a RF rate based on historical data assumes that future economic conditions will be similar to those of the period used to calculate normalized rates. There is no guarantee that the future will look anything like the past. ( )

Another argument against using normalized rates is that RF rates are supposed to represent the opportunity cost of choosing not to invest in a risky asset. In other words, this is the rate you would receive if you didnt invest in the risky asset. Choosing to use a normalized rate violates this principle because you cant invest in a normalized RF rate. The main reason for not using a normalized RF rate is that it introduces our personal opinions and beliefs about the direction of the economy into the valuation. Choosing to use a normalized RF rate changes the estimate of the companys cost of capital used in the valuation, which impacts its final value. The final valuation will be a combination of your views on the company and the direction of interest rates. Although its impossible for a valuation to be completely free of personal opinions, they should definitely be minimized. This means that using a normalized RF is inconsistent with the principles of valuation. This means that the RF rate used in a valuation should be the actual market rate of interest for a longterm government bond. The RF rate chosen in this valuation was the discount rate for a 10-year US government bond. This was 2.94% at the time of this writing. Beta Betas measure the systematic risk present in a particular stock by measuring of much it moves in relation to the market. I chose to use the Bottom-Up method of calculating beta thats described by Damodaran in his book Investment Valuation. The justification for using this method and a description of the process are discussed below. Regression Betas A popular method of estimating beta is to regress the returns of a particular stock against the returns of an index used as a proxy for the market portfolio over some specified time period. Damodaran believes that this method has several issues that make it unsuitable for use in valuations. These include choosing an index to proxy the market portfolio, the time period over which returns are regressed, and the time period that the returns are computed over. Table XX Illustrates the different estimates of EOGs beta after changing various parameters. The most notable change occurred when changing from weekly to monthly returns for two year betas on both indexes. This leaves us with the question, is there a better way to estimate beta?
Table 1: Which one is the right beta?

S&P500 Years

Russell 3000

Weekly Monthly weekly Monthly 2 1.45791365 0.61360676 1.43602097 0.69480792 3 1.39785849 1.45357865 1.3554658 1.444926592 5 1.310784199 1.33518625 1.27033302 1.314227199

Bottom-Up Betas In his book, Investment Valuation, Damodaran says that while regression may be used to estimate beta, its the firms fundamental decisions that determine it. A firms beta is dependent on the type of business or businesses its in, their degree of operating leverage, and their financial leverage. The more sensitive a sector is to market conditions or discretionary its products are, the higher its beta. A firms operating leverage is defined by the relationship between its fixed and variable costs. Firms with a higher operating leverage will have large deviations in EBIT. This increases a firms beta, holding everything else constant. Similarly, higher levels of financial leverage increase variation in net income due to interest payments, which increases beta. Bottom-up betas are calculated by first breaking betas down into their business, operating leverage and financial leverage components. To do this we must unlever a firms beta using the following equation: ( Where: = Levered beta for equity = Unlevered Beta t = Corporate tax rate D/E = Debt/Equity Ratio This equation was first developed by Hamada in 1972. According to Damodaran, if we assume that all of a firms financial risk is taken on by its stockholders, then the beta of debt is zero. This means that the levered beta of a firm reflects the type of business the firm operates in and the amount of financial leverage its taken on. The unlevered beta of a firm reflects the firms level of business risk and also the firms operating leverage. The first step in calculating a bottom-up beta is to separate the firm into its separate businesses. After that, find other companies operating in each of the firms separate business and compute an average (or median) beta for each business. Unlever this average beta by the using the average (or median) D/E ratio of each business. Then, compute the firms unlevered beta by computing the weighted average of each of the individual businesses the firm operates in. The weights are derived using the proportion of firm value derived from each business. Finally, compute the levered beta by estimating current market values for debt and equity and use that D/E ratio to estimate the levered beta. Damodaran states that one of the main benefits of bottom-up betas is the reduction in standard error. Even though the individual betas used in the calculation may be noisy, averaging across each individual business provides a significant reduction. The bottom-up beta also reflects the firm as it exists today because its based on the current weightings of its different businesses. This means that the beta ( )( )

estimate can be easily updated to reflect changes in business mix. Lastly, the estimate is based on current levels of debt, not the average level of debt over the time period of the regression. In my opinion these are significant improvements over regression betas. The following section outlines the general process I used to calculate EOGs bottom-up beta. Calculating EOGs Beta The main criteria I had for selecting comparable firms was that their primary line of business had to be exploration and production because this is EOGs only line of business. I chose to filter out firms with significant refinery operations or those that operated primarily outside of the US because those firms have different risk characteristics than EOG. I also chose to filter out firms who primarily operated in the Canadian oil sands for the same reasons. The final group of comparable firms consisted of 20 companies with market caps between $5,000MM and $40,000. To calculate the average leveraged beta for the group of comparables I averaged their three-year regression betas using weekly prices. In Damodarans work, he says to use market D/E ratios to de-lever the averaged betas, but I am unsure of whether he means the Debt/Market cap ratio or the market value of debt divided by the market cap. I could not think of a time efficient way to calculate the market value of debt for 20 companies so I chose to use the firms debt/market cap ratio. I averaged these D/E ratios and then used this to delever the average beta previously calculated. The average beta was delevered by dividing it by (1+(1-t)(D/E)). The tax rate used was the US marginal corporate tax rate of 40%. The results of these calculations can be seen in Table XX.
Table 2: Inputs used to calculate bottom-up beta (Source: Capital IQ)

Average Levered Beta 1.51

Average D/E Ratio 0.29

Average Unlevered Beta ( ) 1.26

Average Unlevered Beta adjusted for Cash Balance (Sector Beta0 1.30

The cash adjustment seen in Table XX is made to account for the fact that companies usually invest cash in risk-free instruments ( =0). Cash has the effect of lowering the unlevered beta (business beta) because its calculated as the weighted average of all its components. Assuming that cash has beta of zero allows us to simply divide the average unlevered beta by (1-CashW) to remove the impact of cash balances (CashW is equal to the firms total cash divided by its enterprise value). This beta is known as the pure business or sector beta. In this case, choosing to remove the effect of cash from the unlevered beta does not have that big of an impact because the average cash balance of E&Ps is only around 2.5% of their enterprise value. The next step is to calculate EOGs unlevered beta by adding back in the effect of EOGs cash balance on sector beta. This is done by multiplying the sector beta by (1-CashW-EOG). After that, you have to relever the beta by multiplying it by (1+(1-t)(D/E)). EOGs market D/E ratio was used in the calculation. I

estimated the market value of debt for EOG by turning all the debt on their books into a single coupon bond. The value of this bond is the market value of debt. This method is illustrated by Damodaran in his book Investment Valuation. EOGs final levered-beta was estimated to be approximately 1.37. The results and inputs to these calculations can be seen in Table 3.
Table 3: Final inputs and values for bottom-up beta (Source: Capital IQ)
Mkt Debt EOG 6276.77 Mkt Cap 46176.50 Mkt D/E 0.14 Cash/Firm Value 0.03 Adjusted for cash 1.26 Re-levered Beta 1.37

The benefits of using a bottom-up beta over a regression beta can be comparing the standard errors of the two methods. The beta estimated by regressing EOGs weekly returns against those of the S&P 500 over a 3 year period was 1.30 and had a standard error of .098. This means that there is a 67% chance that EOGs true beta is between 1.398 and 1.202 (1 std. deviation). The beta estimated using the bottom up method was estimated to be 1.37 and had a standard error of .035. This means that even at the 95% confidence the bottom up beta will be within .07 of EOGs true beta. This is a huge improvement over the beta estimated via regression. Equity Risk Premium The Equity Risk Premium (ERP) is the expected return above the RF rate of return that investors demand for investing in equities. According to Damodaran, the ERP reflects fundamental judgments that we make about how much risk we see in an economy/market and what price we attach to that risk. This means that the ERP represents the hopes and fears of all investors. When fears (hopes) about the market rise, the ERP also rises (falls) to reflect these fears, and stock prices fall (rise). There are three ways to measure the ERP. These include using a historical (normalized) rate, surveying investors about their expectations of future returns, and calculating an implied ERP. The estimation of both historical and implied ERPs will be discussed in the following sections. Historical ERP This method measures the actual returns on stocks over those earned on a default-free security over a long time period. Using historical ERPs suffer from many of the same issues as using normalized RF rates. The main issue deals with selecting the time period over which to estimate the ERP. How far back in time should you go to estimate the premium? Some analysts choose to go as far back as possible, while others choose shorter time periods that may only go back 10, 20 or 30 years. Proponents of using extremely long time periods claim their estimates are the best because they contain less noise. Those who use shorter periods believe theirs are better because the risk aversion investors is likely to change over time and a shorter time period includes more recent estimates of the ERP. Damodaran notes that estimating the ERP using historical data yields estimates with a significant amount of standard error regardless of the length of estimation period used. He says that using time periods of less than 25 years have standard errors larger than the actual ERP. Even using 80 years of data will still yield and ERP with a standard error of 2.2%.

Implied ERP An implied ERP is calculated by using the formula for the value of a stock to back out the expected return. This is accomplished by computing the IRR of the S&P 500 (or any index) and then subtracting out the RF rate. Implied ERPs dont require historical data to be estimated. They assume that while individual stocks may be mispriced, the market is correctly priced in the aggregate. One of the main advantages to using an Implied ERP over a historical ERP is that they allow you to remain market neutral. In contrast to historical ERPs, implied ERPs dont force you to make assumptions about the direction they are heading. Another advantage of implied ERPs over historical ERPs is that they are forward looking. This is because implied ERPs are estimated using a valuation model which uses expectations of future cash flows. ERPs vary over time due to changes in investor risk aversion and changing macroeconomic conditions. Implied ERPs do a much better job of reflecting these changes than historical models. This is because they are based on current expectations and not on historical data. The implied ERP I will be using in this valuation is 5.19%. This is the premium calculated by Damodaran every month; its available on his website. Final Thoughts on estimating the ERP When weighing the merits of using a historical versus using an implied ERP, the scale is clearly tipped in the direction of implied ERPs. They are a forward looking number instead of backward looking like historical ERPs. They allow you to remain market neutral and not bring your assumptions about the future direction of the ERP into the valuation. Finally, they are dynamic enough to reflect current changes in macroeconomic conditions and changes in the risk aversion of investors.

WACC and Cost of Equity

To calculate EOGs cost of equity, we simply multiply an implied ERP of 5.19% by EOGs beta of 1.37 and add the current RF rate of 2.9%. This gives us a value of 10.34% for EOGs cost of equity. To get from the cost of equity to a WACC, we must weight EOGs cost of equity and cost of debt by their market value weights of both debt and equity to total capital. Doing this gives us a value of 9.25 for EOGs WACC. EOG is an industry with an extremely variability of returns due to volatile commodity prices. This means EOGs WACC should be higher to reflect that risk. I feel that the calculated WACC of 9.25 is high enough to do so.

Valuing EOG using FCFF

I didnt realize it at the time, but I made my life a lot more difficult when I decided to choose EOG this project. They are lacking single major component required by many valuation models-Free Cash Flow. Due to their extraordinary capital expenses, they havent had any free cash flows since 2005. Since EOG has been paying a dividend for a long period of time, I thought I could get around this by using one of the dividend discount models. Every model I tried severely undervalued the stock with anything remotely resembling a realistic growth rate. All of them required extremely unrealistic long

term growth rates to approach for the price to be greater than $50/share. I believe this is because their dividend yield is so low. They are only paying out 75 cents annually which means their dividend yield is only 0.44%. This meant I was forced to use one of the FCF models. To get around their negative FCF, I had to project their earnings into the future until they had positive FCF. The following section discusses the assumptions and methods I used to accomplish this. Getting to Positive FCF Management has said they would be cash flow positive between 2014 and 2017 at several recent presentations. The results of my projections lead me to believe that EOG will have positive a FCFF of $2,086MM in 2015. This is dependent on their continued high growth in oil production and holding their capex close to the same levels. EOGs Growth Rate While EOGs revenues have grown at a CAGR of 42.6% between 2009 and 2012, this is not likely to continue forever. The main driver of EOGs revenues is their oil production. Their oil production growth has been extremely high due to their large holdings in the Eagle Ford and Bakken/Three Forks formations. As discussed in my analysis of the industry, the production characteristics from unconventional plays is not uniform across its entire surface area. I feel that EOGs high growth in oil production is due to them developing the best areas of the play first. This means their production growth will start to decelerate as they run out of prime areas to drill. This deceleration will occur until growth starts to become stagnant and eventually turns negative. Once this occurs, the high decline rates of unconventional wells will start to catch up with them and production growth will start to turn negative. My projections of EOGs future production can be seen in Table 4. Oil production starts out growing at 39% and then starts to decelerate. Their total oil production peaks around 2019 and then starts to fall as fast well decline rates overtake the production from new wells. I believe that the decline in gas growth will start to decrease and eventually turn positive as EOG has no other choice but to develop gassier areas. I assumed the production of NGLs would follow along the same lines as oil production.
Table 4: EOG's Forecasted Revenues from Production Source: Capital IQ
2011 Total Oil Production(MMbbl) % Change Total Gas Production (MMboe) % Change Total NGL Production (MMbbl) % Change Revenues % Change 41.39 0.52 104.23 -0.05 15.48 0.39 6881 0.40 2012 57.79 0.40 98.90 -0.05 20.46 0.32 7962 0.16 2013E 80.33 0.39 89.01 -0.10 23.73 0.16 10445 0.31 2014E 104.43 0.30 78.33 -0.12 26.11 0.10 12463 0.19 2015E 133.67 0.28 66.58 -0.15 28.19 0.08 14905 0.20 2016E 167.09 0.25 59.92 -0.10 29.60 0.05 17815 0.20 2017E 200.50 0.20 58.73 -0.02 30.20 0.02 20821 0.17 2018E 224.56 0.12 60.49 0.03 31.10 0.03 23069 0.11 2019E 235.79 0.05 63.51 0.05 30.17 -0.03 24111 0.05 2020E 233.43 -0.01 66.69 0.05 30.47 0.01 23989 -0.01 2021E 224.10 -0.04 70.02 0.05 29.86 -0.02 23201 -0.03 2022E 203.93 -0.09 73.52 0.05 28.37 -0.05 21403 -0.08 2023E 183.54 -0.10 77.20 0.05 26.95 -0.05 19593 -0.08

While EOGs production revenues start off with an extremely high growth rate, it starts to slow due to deceleration of oil production growth. These forecasts are made assuming prices of $90/bbl, $24/BOE and $45/bbl for oil, gas, and NGLs respectively. Growth in revenues, along with oil production, start to turn negative around 2020. Revenues from production will grow at a CAGR of 8.6% over the period. Their total revenues also include revenues from gathering and marketing activities. These are the revenues from their rail lines. I assumed those would also grow along with production revenues. To calculate the growth in FCFF, I forecasted the required statement items along with revenues. Future capex was based on the equation obtained by regressing historical production and historical capex. This regression had an RSQ of .94, which means capex is a good predictor of total production. DD&A was also estimated via regression. The regression between DD&A and capex had an RSQ of .97. NWC was projected as a percent of revenues as Damodaran does in his teachings. COGS are composed mainly of costs due to exploration and production so I also projected it as a percent of revenue. The results of these can be seen in Table 6. FCFF grow at a CAGR of 10.41% between 2015 and 2023. The entire model can be downloaded from my Dropbox account from the following link: Download Model
Table 5: EOG's Cash Flow Forecast
2012 EBIT EBIT(1-t) DD&A CAPEX NWC FCFF 1287 792 3170 7355 -66 -3328 2013E 2187 1345 3472 6906 179 -2268 2014E 5584 3434 3886 8669 235 -1583 2015E 12871 7915 4459 9730 280 2364 2016E 15393 9467 5282 11257 335 3157 2017E 18399 11315 6240 13035 400 4120 2018E 21502 13224 7021 14484 468 5294 2019E 23825 14652 7410 15205 518 6339 2020E 24900 15314 7443 15266 541 6949 2021E 24774 15236 7250 14908 539 7040 2022E 23961 14736 6719 13924 521 7011 2023E 22104 13594 6189 12941 481 6362

Getting a Value for EOG To get their total enterprise value, I discounted each FCFF by EOGs WACC. This process can be seen in Table 7. I assumed EOGs terminal growth would be 2%, which is lower than that of the economy. This is because North Americas oil is a finite resource. Popular consensus is that after unconventional start to slow down, its over for North America. Summing these discounted cash flows gives us a value of $58,929MM for EOGs debt and equity. Getting to equity value requires adding back in cash and marketable securities and subtracting out debt. This gives a value of $52,652 for EOGs equity.
Table 6: Discounting Cash Flows
2014 FCFF Total Discount Factor PV of Cash Flow 1583.11 1.09 1449.13 2015 2364.08 1.19 2016 3156.74 1.30 2017 4120.31 1.42 2018 5293.95 1.56 2019 6338.97 1.70 2020 6949.11 1.86 2021 7039.50 2.03 2022 7010.73 2.22 2023 6362.17 2.42 101865.77 42071.40

Undiscounted Terminal Value 1980.86 2421.18 2892.77 3402.19 3729.01 3741.97 3469.84 3163.20

To get to share price we must take into account the dilution caused by management options. One way of doing this is by valuing them using the Black Scholes model. EOGs management options have a weighted average exercise price of $85.81. Using the three year standard deviation of 0.26, a risk free rate of 2.90% and an average maturity of 5 years gives us a value of $78.11 per option. Multiplying this by the total amount issued gives us a value of $4,842 for management options. Netting this out of the total equity value and dividing by the number of shares issued gives us a share price of $179.95.

Accounting for Volatile Commodity Prices Since EOGs revenues are dependent on commodity prices I feel some other price scenarios should be examined. Since oil prices are the main driver of EOGs revenue, we will look at the impact have on their value. I believe that the possibility of extremely low oil prices is low. I feel there is a much stronger possibility of extremely high prices in the future. Therefore I will look at the impact of oil prices at $75.00/bbl and $130.00/bbl. All other variables are held constant. If we assume and environment with oil prices that are $75bbl, EOGs share price will be $113.00/share. This is approximately 37% less than our previous value. If oil prices increased to $130/bbl EOGs stock price would jump to $400.63/share. Although this isnt a very realistic exercise, it helps highlight the impact of commodity prices on an E&Ps value. Valuing the firm with Simulated Commodity Prices To set up the simulation I first fit distributions to historical oil, gas, and NGL prices that were adjusted for inflation. Palisades @Risk software chooses the distribution that has the highest Chi-Square value. This measures the goodness of fit between the data and the distribution. The best fit distributions for oil, gas and NGLs were logistic, lognormal, and normal, respectively. These distributions were then linked to the price input on my revenue model and ran 10,000 simulations The simulation yielded a mean firm value of $65,424 with a standard deviation of 17,325. This means that theres a 67% chance that true firm value will be between 82,749 and 48,099. Calculating share price from the given
Figure 1: Results from Simulation

mean yields a price of $203.74/share. Figure 1 shows the distribution of firm values calculated from the simulation.

I feel unsure of the precision of this model. I

did not include account for the correlation between oil, natural gas and NGL prices. This simulation does help to show the impact of price changes on share price better than our previous analysis. Instead of holding prices constant through the valuation, different prices are used to calculate revenues for every period of the valuation. It also changes the values of all through products instead of just oil. To calculate Best/Worst case values for EOG, I used the standard deviation of firm value estimated from the simulation along with the firm value calculated from my original valuation. Table 8 shows the differences in firm value and share prices between my best, worse and base scenarios. The best case scenario is based on high commodity prices while the worst case is based on low prices.
Table 7: Best, Base, and Worst Case Scenarios

Best Firm Value Share Price


Worst $41,694 $116.82

$76,164.00 $58,929.32 $267.21 $179.96

Conclusions Regarding EOGs Intrinsic Value

I think it should be clear that oil, gas, and NGL prices have a huge impact on an E&Ps value. While we dont know the actual prices used to calculate firm value during my best/worst case scenarios, I still feel its better than the sensitivity analysis I did using oil prices. This is because the simulation doesnt hold prices constant throughout the entire valuation and it also changes more than one price at a time. In my opinion using plus or minus one standard deviation from my average base price just makes more sense. Even though this analysis says that EOG is 6% undervalued, I still believe that it is a hold. I feel that 6% is just too small of a difference in value to make it a buy for an E&P.