It may seem rather risky to discuss the appeal of energy companies at the present time. After all, the sector has been hit exceptionally hard by a falling oil price which is showing little sign of recovering towards $100 per barrel over the medium term. As such, further pressure on the top and bottom lines of companies operating within the energy space could be on the horizon.
Valuations
However, there seem to be sufficient margins of safety on offer among a number of sector incumbents, so that even if there is a further fall in the value of assets, it may not lead to a large dip in investor sentiment. In other words, more bad news flow seems to be priced in to the valuations of a number of energy stocks, which indicates limited downside and considerable upside potential.
For example, Premier Oil (LSE: PMO) trades on a price to book (P/B) ratio of just 0.65 and this shows that, even if its asset base were to fall in value and be written down by 35%, Premier Oil would still be trading at net asset value. Furthermore, Premier Oil is expected to bounce back into profitability next year and follow this up with earnings growth of 27% in the following year. When combined with a price to earnings (P/E) ratio of 26.9, this equates to a very appealing price to earnings growth (PEG) ratio of just 1.
Risk
Of course, Premier Oil remains a relatively risky investment. That’s because there is scope for further write downs and for profitability forecasts to be revised downwards. Furthermore, it yields just 0.5% and, as such, offers little in the way of income prospects.
Therefore, teaming it up with a lower risk, better diversified company such as Centrica (LSE: CNA) makes sense. It has a gas production division that accounted for 42% of its operating profit in 2014 as well as its domestic energy supply business which makes up almost all of the remainder. As such, Centrica offers a more diversified business model than most energy companies, with the supply of domestic energy being a relatively stable and consistent space. Therefore, teaming Centrica up with Premier Oil could be a sound move, since it provides the best of both worlds.
For example, while Centrica’s bottom line may not be expected to grow rapidly over the next couple of years, it offers excellent income prospects and an appealing valuation. In fact, Centrica currently yields 4.6% even after rebasing its dividend and also trades on a P/E ratio of just 14.6. And, with dividends set to become an even more important part of total returns for many investors as a result of an expected loose monetary policy over the medium term, good value, high-yield stocks such as Centrica could see their share prices bid up by income-seeking investors.
Looking Ahead
Clearly, a falling oil price would hurt the bottom lines of both Premier Oil and Centrica. However, their mix of great value, high income prospects and excellent growth potential means that the risk/reward ratio appears to be very favourable. Therefore, a mix of the two stocks seems to be a logical move for long-term investors.