Valuation Challenges in Stranded Asset Scenarios: A Risk Discourse of Evidence From the UK

Introduction

Some of the world’s most valuable and powerful companies, that is energy companies, have a huge problem that may either reduce their intrinsic future value due to the risks and uncertainties attached to their future cash slows, or make the shares to be totally worthless. These companies have substantial billions of dollars’ worth of proved reserves made up of coal oil and gas under the heading of ‘unsold inventories’ in their balance sheets. Owning much of these reserves is the source of massive power and high market value¹. Power derives from the incidence of the existent ‘global technological society’ where essentials of such as food, commerce, communication, transportation and industry are driven by these energy mix, whilst their value derives from the intrinsic valuation (commonly based on the present value of future cash flows arising from the sale of energy products). In 2018, $2 trillion in global annual revenue was generated by upstream (exploration and drilling activities) energy companies, and the sector generates up to $90 billion in GDP, representing up to 3% of the global economy². In recent times however, the declining value of these companies has become a source of worry to institutional investors because the future returns accruable to the beneficiaries of institutional investments are linked to the ability of the investee companies to generate future cash flows which is reflected in their respective market capitalisation. As at August 2019, market capitalisation of the top 20 of the world’s energy companies is worth $1.7 trillion which reflects a 55% cumulative decline when compared with the highest value ever attained (see table 1). Literature reveals that the declining value is traceable to factors such as stigmatization by environmental campaigners, legislative uncertainties multiple compression arising from weakness in corporate governance, and divergence in the basis for valuation in the investment community. Recent empirical evidence has shown that stigmatisation can influence compression in trading volumes whereby a misalignment exists between ability to generate future cash flow and intrinsic value. For instance, Rosneft produces 2.3 million barrels per day, which is slightly more than ExxonMobil. However, Rosneft is valued at roughly 18% of the value of ExxonMobil. The problem of uncertainty about the future, and the problem of environmental risks have called into question, the validity of the Gordons growth model used in estimating over or undervaluation of shares (Cho, 1988). These uncertainties may lead to lower intrinsic valuation of equities in these companies due to greater worries about their ability to generate future cash flows, or in worst case scenario, inability to finance new projects leading and the inability to generate fresh working capital, therefore making it impossible to continue as a going concern.

Source: Researcher’s findings.