Determining the fair value of an asset is both art and science. While traditional metrics such as Price/Earnings (PE), Price/Book (PB), and dividend discount models offer the appearance of precise mathematical answers, these methods are widely used and do not often provide investors an edge. Over the years, I have often used nontraditional metrics as a way to determine fair value targets and identify trading opportunities.

One example is the method I use to value energy stocks. Most integrated oil companies trade at low P/E multiples with high return on equity (ROE) and sizable dividend yields. With energy prices very volatile, we must assess whether the low P/Es are a function of high energy prices or sustainable business models. Never comfortable applying multiples to peak earnings, I search for alternate approaches.

An alternative metric I have used for energy companies is to examine the reserves each company reports and the current price of energy, and then determine a market value based on the reserve estimate. 

With any alternative method, we must ask if the process intuitively makes sense and why it would be a valid measure of fair value.  The business of energy companies is to discover, drill, and sell energy. Their reserves offer a view of future production and future earnings. This alone may offer justification to value a company based on reserve value, but I think a private equity perspective helps as well. The oil future market is deep and liquid. If a company is sitting on reserves, their management should be capable of determining when the oil and gas will come out of the ground and be ready to sell. If you know when the energy can be delivered, you are capable of using the futures market to sell your production at prevailing prices at various dates in the future. The cash received from the futures market could then be used to take a company private.  After all, if the stock market values your energy reserves at a discount to the future market's view of energy prices, sell your energy at the higher price, buy back your stock in a leveraged buyout, drill the needed oil to satisfy your delivery obligation, and retain the excess money as profit.

I have been using this metric with conservative assumptions for many years to determine whether energy companies were inexpensive or not. Over the years, this approach has served me well as I have consistently purchased energy company shares at nearly a 20% discount to a conservative fair value estimate.  But looking at the market now, something has changed.

XTO Energy (XTO) is an energy company whose oil and gas reserves are located in North America. While I'm attracted to a company with reserves in geopolitically safe areas, I am always looking to buy shares below fair value. Currently, XTO trades above my reserve value estimate. This indicates that XTO is overvalued relative to energy prices on a long-term basis. Over the short term, XTO has a 0.6 correlation to the price of oil. This means that for every $1 that oil declines, XTO should drop $0.60. This relationship has also broken down. Oil has fallen 9% since reaching a recent high on September 16. Over the same period, XTO has fallen 0.5%.

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With XTO expensive relative to its reserve value and overbought versus its relationship with oil prices, only a sustained rally in the price of oil can justify XTO not declining. Given the technical damage oil has suffered, a rally is unlikely. As the market realizes this, XTO is sure to decline. Looking to profit from the drop, I recommend a short position in XTO as this week's fundamental trade.

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Note: At the time of this article, I am short XTO.