Energy stocks still a great buy

By Jon Markman

If you're mad as hell about higher gas prices, there's really only one way to fight back that makes any sense: You just have to buy an oil company, or at least shares of one, so you can get a piece of the profits.

Although it might seem a little late for that -- major oil producer stocks are up 70% over the past two years, after all -- the truth is that energy companies are still unbelievably cheap.

They are so cheap that many veteran fossil-fuel-business executives and board members are nearly as busy buying their own companies' shares on the open market these days as they are buying private jets, pro sports franchises and seaside estates. On April 2, billionaire Chesapeake Energy (CHK, news, msgs) chief Aubrey McClendon, for one, bought 500,000 more shares of his company after it was already up 500% in the past five years.

How cheap? Well, one of my mentors likes to say that you "can't buy dimes for nickels," which is a warning to avoid stock market bargains that may prove too good to be true. Yet in this case, as you'll see in a moment, it's almost like buying quarters and silver dollars for nickels, as their soaring earnings potential has far outpaced current valuations. Lehman Bros. just Tuesday boosted target prices for virtually all of the energy stocks it covers, even though most are already up 50%-plus in the past nine months.

The 'what's it worth' tool

To understand how inexpensive the oil and gas explorers, drillers and service providers are, you must recognize a few things about stock market valuation. I'm going to go through this seemingly basic drill because I learned after speaking to readers at The Money Show in Las Vegas last week that many people don't know how shares are priced.

First, a stock's value has virtually nothing to do with its absolute price per share, such as $5 or $50. Those are just numbers. Valuation stems from two factors: the amount of future profit that each share represents and the multiple of that profit that investors are willing to pay now depending to their confidence that those earnings will come to fruition.

When investors are exceedingly sure of a company's growth prospects, they are willing to pay very high multiples of expected earnings in order to own a piece of that success. This results in a high price-to-earnings multiple, also known as a P/E ratio.

When investors are morose about a company's growth prospects or are simply uncertain, they become stingy about the multiple they're willing to pay, resulting in a lower P/E multiple.

Now you see why I often call the P/E multiple the "secret lever" behind stock prices. Two groups of investors with the same expectation for a company's future earnings power could come up with vastly different target prices if they have different levels of confidence in their expectations and thus use different multiples.

• Talk back: Do you think now's the time to buy energy stocks?

So what's the right multiple? As a rule of thumb, stocks are considered fairly priced when their P/E multiples are equal to their expected future growth rates -- so it's normal to see investors apply a 20 P/E multiple to a company expected to grow by 20% annually over the next couple of years. Google (GOOG, news, msgs), as an example, is expected to grow around 25% annually yet sports a P/E of 35 because investors have a high level of confidence that it will surpass expectations.

Big consumer-staples manufacturers, such as Colgate Palmolive (CL, news, msgs), often are given a P/E that's double their growth rate because investors are so sure they won't disappoint. On the other hand, companies whose businesses are considered highly cyclical, or captive to the ebbs and flows of the broad economy, are stuck with P/Es that are lower than their growth rates -- in some cases, much lower.

No bubble, no cycle

That's where energy companies come in. For many decades, when oil and gas supplies were considered plentiful, the industry was slapped with the "cyclical" label, and therefore its stocks were stuck with low earnings multiples. Wall Street can be very slow to change its ways on such matters, and these companies are still valued as if their businesses are always on the verge of collapse.

This is a crazy situation for two reasons: Energy companies' earnings growth is directly related to the price of their underlying commodity, and both oil and gas futures prices have been on a one-way road higher this decade, doubling in the past year alone. Plus, demand for drilling services has risen dramatically as emerging markets increasingly strain the supply chain. Energy entrepreneur and fund manager T. Boone Pickens, who has called the surge in the fuel complex accurately for five years, told reporters Tuesday that he believes crude prices represent a true demand-supply imbalance and are therefore not in a speculative bubble. He's expecting $150 in crude futures by the year's end, up 13% from prices Wednesday.

So what happens if the rest of the market comes around to Pickens' point of view and ultimately decides to value energy as a growth industry that's no longer subject to big downward swings? That's easy: The stocks will rise dramatically as investors collectively decide to pay more for every unit of earnings at the same time that those earnings are growing tremendously. It's the kind of "secular" sea change in valuation that technology companies enjoyed in the 1990s after they lost their own "cyclical" label.

Here's an example: Texas oil driller Unit (UNT, news, msgs) is expected to earn $8.45 per share in 2009. Shares closed Wednesday at $76.50 after rising 70% in the past six months. Divide the price by the forecast earnings per share and you get a forward P/E of 9.1. That's on a stock expected to grow at least 15% but will probably grow more like 20%-plus over the next couple of years.

That is an absolutely screaming bargain unless you think the drilling business is about to crumble -- which, I assure you, it is not. If investors decide to value Unit like a growth company, they would be willing to pay at least a 15 multiple, which pushes the potential target for the stock to $126, even if the earnings target doesn't move. If the company makes more like $9, as I suspect it will, you can push the target to $135.

Continued: Expect to be surprised

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