When it comes to analyzing a company’s financials, there are many avenues we can take. One way is through multiples; calculating the EV/2P multiple is the focus of this analysis.

This ratio looks at a business’ enterprise value against its proven and probable 2P reserves. While ratios or multiples are used in valuing companies, this metric is used chiefly to value gas and oil companies for energy sector analysts. Analysts use this calculation to determine the likelihood that a company’s reserve resources can underpin its functioning and expansion efforts. Along with the ratio, analysts use micro and macro factors to determine a company’s financial health, its growth prospects, and whether the business is undervalued or overvalued.

This multiple is similar in comparison to other valuation multiples such as Price-to-Book (P/B), Price-to-Earnings (PE), Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization. While these other metrics can also value an oil or gas company, understanding how it’s calculated is essential to why it is sector specific.  

Breaking Down the EV/2P Ratio

EV = Market Value of Equity + Market Value of Debt – Cash and Cash Equivalents

It’s determined by the complete market worth asserted by the bond and equity holders (net of cash).

2P = Proven Reserves + Probable Reserves

The reserves of a company give analysts and investors an idea of the likelihood of the recoverability of reserves being produced and assisting the company’s growth. Proven reserves, often denoted as “P1” or “P90,” are rated at a 90 percent chance of recovering successfully. Probable reserves, also called “P50,” have a 1-in-2 chance of recovering. Both reserve types and their likelihood of being recovered are, therefore, referred to as 2P.  

It’s important to note a third category referred to as “possible reserves.” This category is not factored into the company’s valuation because the 10 percent to 50 percent likelihood of reserve recoverability is too low.  

Example

Illustrating how it’s calculated gives a more complete picture of how to analyze the results. For example, say a business‘ market capitalization is $200 million with a net debt of $100 million, giving it an enterprise value of $300 million. Assuming the company has $10 million of probable reserves, $20 million of proven reserves, and $15 million of possible reserves, the calculation is as follows:

EV = $300 million ($200 million + $100 million)

2P reserves = $30 million ($10 million + $20 million)

Therefore, $300 million/$30 million = $10

Every dollar of its market capitalization is worth $10 based on its 2P reserves. Once the calculation is determined, the ratio of the EV/2P is measured against the energy sector’s average ratio. The higher the EV/2P ratio, especially against its peers, the higher valuation the company has compared to other companies with the same amount of 2P reserves. The company’s shares are sold at a higher multiple than other companies.

It’s important to keep in mind that if a company’s financials are stronger or it’s more efficient and provides a better prospect for investors against its peers, its lofty valuation may be justified. It’s also important to not look at valuing companies exclusively with this ratio/multiple but also review other metrics and the macro-economic conditions before making a final investment decision.

While this multiple is primarily used for the energy industry, those who use it should be mindful to not analyze a company in that lens only, but to use a holistic analysis when valuing any type of company.

The subscription economy, according to Forbes, is expected to reach $1.5 trillion in revenue for businesses. With the potential likely realized this year, it’s vital to understand how it is tracked – and more importantly, how it’s able to be tracked on a separate basis.

Also known as net dollar retention (NDR), this metric calculates the proportion of recurring revenue kept from present clients, including upsells and churn, during a defined time frame. Net revenue retention (NRR) evaluates a business’s potential to keep and increase sales from their present clients.

It looks at how well a company leverages existing customer relationships to increase sales through add-ons, complimentary services, etc. It focuses on the long-term growth of recurring revenue from these relationships. It’s calculated as follows:

NRR = (Starting MRR + Expansion MRR – Churn MRR) ÷ Starting MRR

Based on the following assumptions:

Starting monthly recurring revenue: $200,000

Expansion monthly recurring revenue: $40,000

Churn monthly recurring revenue: $20,000

NRR = ($200,000 + $40,000 – $20,000) / $200,000 = 1.10 or 110%

Based on this result, the company is increasing its revenue from existing customers faster than it’s failing to keep revenue from customer churn, an important metric showing growth.

The following factors impact the formula:

Starting MRR is also referred to as the baseline recurring revenue.

Expansion MRR refers to the added sales from newly added clients, upselling, upgrades, and additions to existing customers’ services.

Churn MRR is the sales missed by customers who stopped or lowered their level and type of services with the company.

Defining a Healthy Revenue Retention Rate

Companies that have a score of more than 100 percent show they’re bringing in more revenue from the existing customer base versus what the company is losing from customer churn. If, however, it’s less than 100 percent, customer satisfaction might be lacking, and customers may either be lost or simply not interested in additional services. Since acquiring new customers is more expensive than keeping current ones, it can lead to reflection on how to improve retention rates.

Journal Entry for Recurring Revenue

Assuming there’s a 12-month contract signed for monthly services, the journal entry would be as follows for a $1,000/monthly payment for a total of $12,000.

Once the $1,000 subscription income has been earned, the following journal entry would be entered.

While each industry and business are different, using this metric can help companies determine if there’s a customer retention problem; then they can start the investigation on how to increase retention for the future.

Sources

https://www.forbes.com/councils/forbesfinancecouncil/2023/10/27/the-truth-about-recurring-revenue/

Return on Ad Spend (ROAS) is one way to help advertising and marketing professionals and investors analyze how well promotions do (or don’t) produce sales. It helps advertisers develop data based on their campaigns’ revenue production (or lack thereof). Understanding how this metric is calculated and how to analyze ROAS is essential for businesses to monitor and increase their advertising performance.

Known as a Key Performance Indicator (KPI), ROAS determines how much sales are generated per dollar invested on advertising outlays. It separates advertising costs from the company’s costs, and it focuses on:

1. The differences between advertising income and advertisement expenses

2. Assisting companies with creating efficient budgets

3. Identifying unprofitable campaigns

How ROAS is calculated:

Return on Ad Spend (ROAS) = Revenue generated from ad campaign/Total advertising costs for a specific campaign

The revenue generated from an ad campaign is the revenue immediately assignable to promotions utilizing a tracking tool.

Total advertising costs for a specific campaign are expenses explicitly connected to the advertising platform.

The resulting calculation determines the business’ return on ad spend, giving owners and managers an idea of how well (or not) ad spending impacts the company’s sales. It similarly enables business owners to reconcile the company’s budgeted advertising costs against growing sales metrics. The following hypothetical breakdown shows what a positive scenario looks like:

A ROAS of 10 = $10 of revenue was earned for every $1 spent on ads. This would translate into:

Total Ad Spend: $10,000

Revenue Generated: $100,000

ROAS = $10

ROAS = 10:1

Important considerations when calculating this include factoring in merchant expenses, costs for digital content production, and costs incurred from media platforms. It’s also important to consider that it’s not always cut-and-dry as to how and what specific ads convert potential customers into paying customers. Assigning the exact ad platform or campaign is a common problem when determining the exact ROAS.

Credit analysis conducted by lenders evaluates ROAS to determine the sales ability of companies seeking loans, especially with promotion-centric companies. The higher the ROAS, the less risk there is and the more reliable the revenue from each campaign. For merger and acquisition professionals, ROAS trends offer insight into a target company’s sustainability. It helps determine if a company’s advertising campaigns can sustain themselves and keep generating future growth.

It’s equally important to see how ROAS compares against other metrics. While ROAS focuses on revenue generated per dollar spent, the advertising-to-sales ratio looks at the total proportion of sales driven by advertising efforts. Similarly, while ROAS measures the revenue per ad spend, return on investment analyzes the comprehensive profitability for the complete level of marketing expenses – not exclusively advertising. While ROAS is a short-term measure on instant sales, Lifetime Value looks at the customer’s history with the company and the entire revenue the company earns from the relationship.

While this metric is helpful for many professionals, it’s important to ensure that only necessary data is included and customer conversion is monitored precisely in order to get the best output.

The CAC Payback Period looks at how a business needs to recover its investment in attracting new customers. It is especially crucial for companies that are in industries with large marketing and sales costs. It’s an important metric because it helps businesses measure their performance in a number of ways.

First, it shows how well a business is managing its budget. Based on the resulting figure of the CAC Payback Period, the shorter the time required to break even on its customer acquisition costs, the more efficient a company is with its sales and marketing expenses. If, however, the result is high, this signals the company is doing something wrong and needs to analyze its current approach.

Running this analysis can also identify a company’s financial perils. The more prolonged the CAC Payback Period, the more likely a company might be facing cash flow concerns. Whether it is caused by overall economic conditions or industry or company-specific challenges, this is another reason for a company to run the numbers to see how it can mitigate or turn around the costs associated with acquiring customers.

The calculation also can help a business determine if it is able to expand to new products and markets and scale up existing product lines. The shorter the time needed to acquire new customers, the more likely a business can grow.

When investors and lenders analyze a company’s financials, including this metric, the more efficient a company is, and the more likely it will attract investors or have lenders offer favorable financing terms.

How to Calculate the CAC Payback Period

This scenario looks at $300,000 in customer acquisition costs, such as marketing, sales, etc., for a three-month period. The company obtained 1,000 new customers and is expected to gain $200,000 in new monthly recurring revenue (MRR), with an estimated gross margin of 60 percent.

First Step: Calculate the CAC by dividing Sales and Marketing Expenses by the new customers (1,000). It’s expressed as follows:

CAC = Sales and Marketing Expenses/Number of New Customers

CAC = $300,000/1,000 = $300 per customer

Second Step: This is to determine the monthly recurring revenue (MRR) per customer. The new MRR amount is divided by the number of newly acquired customers. It’s calculated as follows:

MRR = $200,000/1,000 = $200 per customer

Third Step: Determine the gross margin or how much remains from revenue after subtracting direct costs. In this case, we’ll use 60 percent.

Fourth (and Final) Step: This step determines how many months it will take to recoup the customer acquisition costs from the profits generated by the newly acquired customer. It’s calculated as follows:

CAC Payback Period = $300/($200 x 0.60) = 2.5

Based on the resulting 2.5 figure, it takes, on average, 2.5 months of profit from the newly acquired customers to pay for the customer’s acquisition cost.

Understanding CAC Payback Period Efficiency

If it’s less than 12 months, it’s favorable. This implies a business has an efficient approach to profitability and growth. However, it’s not a hard and fast rule because the repayment time frame can fluctuate based on the economy and the business operations. If a company is a low-margin business or industry (e-commerce, groceries, etc.), a far tighter payback time frame would be necessary to be viable.

There are many factors that can affect this company-specific measurement, such as the industry or sector, current economic conditions, or the business’ approach to gaining new customers. If a company has a shorter CAC Payback Period in an industry that has a generally accepted longer one, this can imply that the company is more efficient in its operations.

This metric is another tool in a financial analyst’s toolbox that can measure and identify efficiency (or lack thereof) and help put businesses back on track for greater financial health.

No matter the type of business or industry, being able to analyze and deduce patterns is essential to discovering a business’ financial health. Here are four commonly used calculations to help internal and external stakeholders determine an organization’s ability to manage its finances.

Break-Even Analysis

This formula analyzes fixed costs versus the profitability a business earns for every extra item it creates and sells.

Businesses that have smaller thresholds to meet their fixed costs to realize profitability have an easier break-even point to meet and exceed. Once the fixed costs threshold is satisfied and sales revenue outpaces variable costs, a business will know when it hits the break-even point.

Break Even Point (BEP) = Total Fixed Costs/(Price Per Unit – Variable Cost Per Unit)

This takes the total fixed costs divided by the price per individual unit minus each unit’s variable cost.

Examples of fixed costs are rent, taxes, insurance and wages. Examples of variable costs are raw materials, production supplies, utilities and packaging.

Another way to determine a company’s break-even point is as follows:

Contribution Margin = Item Price – Variable Cost Per Unit

This is illustrated by: $55 = ($85 – $30)

The item’s priced at $85, with a variable cost of $30, the contribution margin is $55 of how much revenue a company earns to pay for the remaining fixed costs.

Cash Ratio Formula

The cash ratio formula offers one way to look at a company’s liquidity position by comparing a company’s cash and cash equivalents to its current liabilities or debts due within the next 12 months. It shows how well positioned a business is (or is not) able to pay debts due within 12 months, and to satisfy the near-term obligations of its long-term debt.

It’s an important ratio that lenders look at when evaluating a company’s loan application. Instead of including assets such as accounts receivables, it factors in a business’ ability to take care of its financial obligations. It’s thought of as being a more real world look at how financially stable a business is.

It’s calculated as follows: Cash Ratio: Cash + Cash Equivalents/Current Liabilities.

Gross Profit Margin

This is defined as all income minus the cost of goods sold (COGS). COGS is comprised of expenses attributable to the creation of products, which include input materials and salaries for workers to produce such goods. However, it excludes expenses for taxes, overhead, debt, asset acquisitions, etc., among others. Another way to explain this calculation is to ask how much a business retains as profit once production costs are accounted for.

It’s calculated as follows: Gross Profit Margin = [(Net Sales – Cost of Goods Sold)/(New Sales)] x 100

Debt-to-Equity (D/E) Ratio

This is used to determine how much debt or financial leverage a company has on its books. It tells internal stakeholders and external parties what percentage of debt a company is using to operate compared to the business’ available operating reserves. This ratio contrasts a business’ complete financial obligations against its shareholder equity. Its primary use is to see how extensively it uses debt to operate.

It’s calculated as follows: Debt/Equity Ratio = Total Liabilities/Total Shareholders’ Equity.

While these calculations may seem straightforward, these are only a few examples of how businesses can calculate and analyze a company’s position – be it the owner, an employee or an outside lender or investor.