Incorporating Tunneling Risk into Equity Valuation: an Application to the Oil and Gas Industry

Abstract

Consider a firm that has high profitability and sales growth relative to peers but a relatively low Tobin’s Q. An ad hoc analysis of that particular firm’s situation might suggest that the apparent valuation discount is caused by off-balance sheet risks. A more systematic framework would be useful to support and confirm the conjecture. This paper offers such framework by first classifying transactions that managers and controlling shareholders can use to tunnel (expropriate wealth) from firms into three types: cash flow, asset, and equity tunneling and then incorporating each type of tunneling into a firm free cash flow valuation model. Based on the model, each type of tunneling affects observed valuation and profitability ratios differently, providing analytical markers useful for determining priced tunneling risks. We apply the integrated tunneling and valuation framework to an analysis of the global oil and gas industry. Cross-sectional and time series differences in the patterns of valuation metrics indicate that the valuations of Russian oil and gas companies are depressed relative to their global peers due to significant asset and equity tunneling risks, but also that investors’ assessment of these tunneling risks changes significantly over time. The results demonstrate that analyzing tunneling risks can enhance existing equity valuation tools.