Origin of the Term

The phrase rule of thumb first appeared in print in 1685 in a posthumous collection of sermons by preacher James Durham. He wrote:

Many profest Christians are like to foolish builders, who build by guess, and by rule of thumb (as we use to speak), and not by Square and Rule.

Historically, the rule of thumb referred to using the width of ones thumb as an informal measuring tool. The term rule here could denote either a ruler or a guideline, giving rise to the modern usage of the phrase.1

Valuation Context

In valuation, a "rule of thumb" refers to a multiple derived from an extensive analysis of industry-specific market transactions over time, often based on verified sources. Although these rules are frequently cited as reliable, their accuracy can fluctuate depending on specific circumstances.

Common examples include:

  1. 5x EBITDA for a private company
  2. 1x sales for a consulting firm
  3. $200 dollars per foot for homes in a certain neighborhood

While these rules simplify communication and enhance understanding in valuations, market-specific conditions can render them less effective compared to a more comprehensive appraisal.

Oil and Gas Rules of Thumb

In the oil and gas industry, four common rule-of-thumb methods often seen include:2

  1. Price paid per barrel of equivalent (BOE) of reserves3
  2. Price paid per equivalent barrel per day of production
  3. Profit to investment ratio
  4. Current income rate for a specific period of time

One challenge with using rules of thumb in oil and gas is that they resemble driving a car while only watching the rear-view mirror: as long as future conditions resemble past conditions, these methods work. But market disruptions — such as wars, strikes, or embargoes — can quickly expose their limitations.

Oil and Gas Properties - 3X Cash Flow?

As noted by my colleague and co-author Alan Harp of Stout in his 2013 article,4

Valuing oil and gas properties held by individuals or estates at three times (3x) annual cash flow (“3x Cash Flow”) has been a widely used rule of thumb for decades. More sophisticated users of the rule might apply it only to working interests and apply a higher (say 5x) multiple for royalty or overriding royalty interests (“ORRIs”).

The convention is to simply multiply the trailing 12-month cash flow figure generated by the subject property or collection of properties by three (3) and the result presumably represents the market value of such properties. Numerous CPAs and attorneys have filed estate or gift tax returns using this methodology. Furthermore, many bank trust departments regularly use this methodology when valuing oil and gas properties.

Alan goes on to note that because the approach is so simple and avoids petroleum engineering or appraisal fees, it is widely used, particularly for smaller, nominal properties. However, this rule of thumb is often applied in situations beyond its useful bounds and can result in conclusions that differ dramatically from the actual market value of the subject properties.

3x Cash Flow Rule of Thumb Versus Current Market Data

Valuing oil and gas properties at 3x cash flow is, in essence, a simplified form of the dividend discount model. It assumes that the present value of future dividends, discounted at a risk-adjusted rate, equals 3x the prior years dividend or royalties received.

To compare this rule with current market conditions, we conducted a market-based analysis using guideline public companies (GPCs), focusing on publicly traded royalty trusts which invest in royalties, overriding royalties, net profits interests, and leasehold interests.

Our selection criteria included publicly traded companies with:

  1. Actively traded stocks
  2. Financial solvency
  3. Similar business operations to the subject company or interest

For illustration, we selected ten publicly traded royalty trusts:

Name

Ticker

Chesapeake Granite Wash Trust

  CHKR

Cross Timbers Royalty Trust

CRT

Dorchester Minerals, L.P.

DMLP

Marine Petroleum Trust

MARP.S

Mesa Royalty Trust

MTR

Permian Basin Royalty Trust

PBT

PermRock Royalty Trust

PRT

Permianville Royalty Trust

PVL

Sabine Royalty Trust

SBR

San Juan Basin Royalty Trust

SJT

 

Given that publicly traded mineral and royalty interest companies are traditionally assessed by the market based on their dividend yield, the use of dividend yield in our analysis provides a direct indicator of market value.

In an actual appraisal for a specific asset or holding company, additional factors would also be considered such as size. Various studies document that the price-to-earnings ratios of companies are directly correlated with the size of the company, where size is measured by a number of financial indicators (e.g., revenue, equity market capitalization, and total assets). All else equal, a larger company generally warrants a higher valuation multiple than a smaller company. However, smaller companies can certainly have higher multiples if their growth momentum is stronger, or if their reserves are less depleted than a more mature, larger company (given the depleting nature of hydrocarbon reserves).

Also, most of the guideline public royalty trusts have higher levels of diversification within their asset bases and greater equity market capitalization than an asset or company being appraised. Given that a single asset has a smaller size and less diversified operations, this may suggest increased perceived investment risk in relation to the guideline companies, and all else held constant, indicate that a lower valuation multiple was applicable.

With respect to risk, all else equal, a company with a higher level of perceived risk in its operations and cash flows generally warrants a lower valuation multiple and higher yield than a company with lower perceived risk.

Illustrative Analysis

Our analysis began by gathering the closing stock price and last-twelve-month dividends from each company as of September 30, 2024.

Implied Pricing Multiples

In Millions of U.S. Dollars, Except Dividends per Share

Royalty Trusts

Ticker

9/30/24 Price Per Share

LTM Dividends Per Share

 

Chesapeake Granite Wash Trust

CHKR

$0.40

$0.09

 

Cross Timbers Royalty Trust

CRT

$10.57

$1.28

 

Dorchester Minerals, L.P.

DMLP

$30.15

$3.34

 

Marine Petroleum Trust

MARP.S

$4.01

$0.376

 

Mesa Royalty Trust

MTR

$5.68

$0.43

 

Permian Basin Royalty Trust

PBT

$11.89

$0.67

 

PermRock Royalty Trust

PRT

$3.95

$0.44

 

Permianville Royalty Trust

PVL

$1.62

$0.07

 

Sabine Royalty Trust

SBR

$61.77

$6.06

 

San Juan Basin Royalty Trust

SJT

$3.70

$0.27

 

 

 

 

 

 

 

Royalty Trusts

Ticker

 

LTM Dividend Yield

Implied Multiple

Chesapeake Granite Wash Trust

CHKR

 

21.0%

4.8x

Cross Timbers Royalty Trust

CRT

 

12.2%

8.2x

Dorchester Minerals, L.P.

DMLP

 

11.1%

9.0x

Marine Petroleum Trust

MARP.S

 

9.2%

10.9x

Mesa Royalty Trust

MTR

 

7.6%

13.2x

Permian Basin Royalty Trust

PBT

 

5.6%

17.8x

PermRock Royalty Trust

PRT

 

11.0%

9.1x

Permianville Royalty Trust

PVL

 

4.5%

22.4x

Sabine Royalty Trust

SBR

 

9.8%

10.2x

San Juan Basin Royalty Trust

SJT

 

7.4%

13.5x

 

 

 

 

 

 

Analysis of Multiples

 

 

LTM Dividend Yield

Implied Multiple

Maximum

 

 

21.0%

22.4x

Upper Quartile

 

 

11.0%

13.4x

Median

 

 

8.4%

10.6x

Mean

 

 

8.3%

11.9x

Lower Quartile

 

 

5.3%

9.0x

Minimum

 

 

4.5%

4.8x

 

We then calculated each company’s dividend yield and its implied multiple, which is the reciprocal of the yield. Lastly, we determine the statistical results for the sample in terms of the mean, median, and upper and lower quartile indications.

For our group of companies, as of September 30, 2024, an investor would expect to pay up to 9x the dividends received over the past year for a property with similar risk and return characteristics. Interestingly, the lowest observed multiple was 4.8x — still significantly higher than the conventional 3x cash flow rule.

Key Takeaways

Current market conditions reveal that the 3x cash flow rule of thumb can understate asset values, especially given today’s regulatory, commodity price, and interest rate environments. Properties with non-producing minerals, or those located near active drilling operations, may also warrant higher valuations. Ultimately, factors such as well location, lease activity, type of interest (royalty vs. working), oil/gas mix, hedging activities, and total years of production history would be considered in establishing a defensible indication of fair market value.

WTI Strip Prices Increase

Spot prices and futures prices for the West Texas Intermediate (WTI) contract increased approximately $5.50 per barrel in the near term and increased approximately $3.00 over the longer term.

WTI Strip Prices - One Month Change

one month change of WTI strip prices

As shown, the oil price curve remains in a state of “backwardation,” reflecting the market’s expectation of lower future spot prices.

Oil Price Outlook

The price distribution below shows the crude oil spot price on October 9, 2024, as well as the predicted crude oil prices based on options and futures markets. Light blue lines are within one standard deviation (σ) of the mean, and dark blue lines are within two standard deviations.

WTI Crude Oil $/BBL

WTI Crude Oil $/BBL - October 2024

Based on these current prices, the markets indicate there is a 68% chance oil prices will range from $60.00 and $89.00 per barrel in mid-January 2025. Likewise, there is roughly a 95% chance that prices will be between $43.00 and $132.50. By mid-March 2025, the one-standard deviation (1σ) price range is $57.50 to $91.00 per barrel, and the two-standard deviation (2σ) range is $38.50 to $140.00 per barrel.

Key Takeaways

Compared to the prior month and week, futures price ranges have increased, which could be in response to the rising tensions in the Middle East as the market awaits Israel’s potential response to Iran. However, President Joe Biden has publicly discouraged Israel from hitting Iran’s oil infrastructure, and it is considered likely that Israel will hit military and intelligence sites in Iran first, according to officials.5

Remember that option prices and models reflect expected probabilities, not certain outcomes, but that does not make them any less useful. Throughout most of 2023 and 2024, crude oil spot prices have primarily fluctuated within the range of $70 to $90 per barrel. During that time, we observed general increases in futures price volatilities as prices neared the upper bound of that range, as evidenced by the futures price ranges observed. For mid-March 2025 pricing as of October 9, 2024, the 1σ range had a spread of $33.50 per barrel, and the 2σ range had a spread of $101.50 per barrel. For comparison, in 2022 we observed 1σ and 2σ price ranges in excess of $65.00 and $150.00, respectively.


  1. "What Is the Rule of Thumb? | Meaning & Origin," Paige Pfeifer, QuillBot, June 26, 2024.
  2. "Valuing the Potential of Land for Oil and Gas Development," David Ammons, Dallas Bar Association, Energy Law Section, January 16, 2023.
  3. For a detailed discussion of the BOE metric and recent market conditions, see Stout's "Is BOE Still Relevant With Today's Commodity Prices?"
  4. "The Valuation of Oil and Gas Properties: Are They Really Worth 3x Cash Flow?" Alan Harp, Stout, March 1, 2013.
  5. "Crude oil futures sell off after surging on Middle East war risk," Spencer Kimball, CNBC, October 8, 2024.