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Overview

Exxon Mobil (XOM) is the largest company in the US by revenue and, until fairly recently, was the largest by market capitalization as well. After an impressive multi-year run, as seen in the weekly chart below, are Exxon shares overvalued? This article will use several metrics and oil price forecasts from the EIA in order to look into 2013 and see what we can reasonably expect from the oil giant next year.

(click to enlarge)

Exxon shares broke above the $85 level early this year that had been pretty substantial resistance up until that point. For this reason, I expect $85 might serve as strong support going forward barring any external shocks. In addition, the shares have pulled off of their high around $92 and can now be purchased for about $85 at the time of this writing. This means that those that are bullish can now purchase XOM a bit more cheaply now, and just above what I believe will serve as significant support, than they could just a couple of months ago.

That's enough technical talk, now we'll take a look at the fundamentals of the company.

Fundamentals

We all know that Exxon's main business revolves around discovering, drilling, refining, transporting and selling crude oil and its derivatives. Exxon is also now a major player in the "alternative" energy space with its $31 billion acquisition of XTO Energy. Even with Exxon's acquisitions over the years, its main business is still heavily slanted towards the price of crude oil and its derivatives, as seen in this chart. The chart below depicts XOM's market capitalization in relation to the price of WTI (West Texas Intermediate) crude oil:

What you can see is that the market value of Exxon Mobil is almost entirely dependent upon what it can charge for the products it discovers, transports and refines; all of which are dependent upon the raw material. What this means is, if you are going to own Exxon shares for their capital appreciation potential, you need to be bullish on the commodity itself, and not necessarily just the company's ability to generate returns from its assets.

This chart of Exxon's return on equity shows a similar story; you can see that Exxon's ROE is also heavily dependent upon the price of WTI crude and therefore, Exxon's earnings are somewhat at the mercy of black gold:

While the numbers are strong regardless of the price of crude, you can see that it is much easier to add return on equity when crude is selling for a higher price, all else equal.

Lastly, let's take a look at Exxon's free cash flow in relation to WTI crude oil prices; we see a very similar story here as well:

While these charts are similar, the take away is that if you are going to own Exxon shares, you must be bullish on crude oil as well or your thesis will ultimately be proven misguided. Knowing how dependent upon WTI crude XOM's price is makes you a better investor in the shares because if you can get handle on what WTI might look like in the near future, you can either catch the price appreciation in the shares or get a better entry point on a dip in prices.

WTI Crude Oil

For the past year and a half, WTI crude has been range bound between about $80 and $110. As of this writing, it is trading just south of $89. The question becomes, give Exxon's share appreciation this year and where crude is trading, what does crude price movement mean for Exxon in 2013? To make a fair estimate of how XOM will perform next year, we first need to forecast WTI crude oil prices in 2013. Given the many variables that can move crude oil prices (geopolitical issues, supply and demand, inflation, US dollar strength, etc.), it can be quite challenging to accurately forecast crude oil prices for any given time period. However, the Energy Information Administration (EIA) produces forecasts for many energy products, including WTI crude. Since they are generally recognized to be the authority on such matters, I have elected to use their forecast for 2013 WTI crude prices. As you can see below, the EIA expects WTI crude to be flat to down in 2013 (the red line). This, of course, means that Exxon will probably suffer some ROE erosion and as a result, net income and presumably, the stock price will suffer. These are assumptions, of course, but given the evidence presented above, I feel they are quite reasonable assumptions to make.

(click to enlarge)

Discounted Cash Flow Analysis

Given this information, we will now take a look at a DCF approach to actually valuing Exxon Mobil shares. First, a few assumptions were made for this analysis. The discount rate I used is 10%, which I believe is fair given that Exxon is relatively low risk and that we need to expect a fair return on our money. Second, the earnings estimates for 2012 and 2013, as well as the growth estimates for the next five years are all derived from Yahoo! Finance analyst compilations. Dividend growth is assumed to be 5% for each year. One last assumption is the perpetual growth rate, which I estimated at 3%. You may disagree with some or all of my assumptions but I believe they are reasonable estimates of what may actually occur; all DCF analyses contain some subjectivity.

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$7.81

$7.91

$8.41

$8.95

$9.52

$10.13

x(1+Forecasted earnings growth)

1.28%

6.37%

6.37%

6.37%

6.37%

6.37%

=Forecasted earnings per share

$7.91

$8.41

$8.95

$9.52

$10.13

$10.77

Equity Book Value Forecasts

Equity book value at beginning of year

$36.56

$42.08

$47.98

$54.29

$61.04

$68.25

Earnings per share

$7.91

$8.41

$8.95

$9.52

$10.13

$10.77

-Dividends per share

$2.28

$2.39

$2.51

$2.64

$2.77

$2.91

$3.06

=Equity book value at end of year

$36.56

$42.08

$47.98

$54.29

$61.04

$68.25

$75.97

Abnormal earnings

Equity book value at begin of year

$36.56

$42.08

$47.98

$54.29

$61.04

$68.25

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

$3.66

$4.21

$4.80

$5.43

$6.10

$6.83

Forecasted EPS

$7.91

$8.41

$8.95

$9.52

$10.13

$10.77

-Normal earnings

$3.66

$4.21

$4.80

$5.43

$6.10

$6.83

=Abnormal earnings

$4.25

$4.21

$4.15

$4.09

$4.02

$3.95

Valuation

Future abnormal earnings

$4.25

$4.21

$4.15

$4.09

$4.02

$3.95

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

$3.87

$3.48

$3.12

$2.79

$2.50

$2.23

Abnormal earnings in year +6

$3.95

Assumed long-term growth rate

3.00%

Value of terminal year

$56.37

Estimated share price

Sum of discounted AE over horizon

$15.76

+PV of terminal year AE

$31.82

=PV of all AE

$47.58

+Current equity book value

$36.56

=Estimated current share price

$84.14

As you can see from the table, given my assumptions and estimates from Yahoo! Finance compilations, Exxon's current value is something like $84 per share currently. Given that it trades at about $85 now, it is fairly valued in my scenario. However, given the risk to crude oil prices in the future (softening demand, increased supply, etc.) and the correlation XOM's price has to WTI crude, my personal feeling is that XOM is not a great place for you to invest your capital in the coming year. The dividend is okay but not great and the chance for price appreciation is also low, in my opinion.

As you can see below, Exxon is terrific at increasing their dividend and if you need a savings account-like vehicle for some income, XOM may be the place for your money; I just wouldn't count on any meaningful price appreciation in 2013. To reiterate the point, Exxon's current yield isn't spectacular but they do have a history of increasing the payout. If you are seeking a stable source of income, you can do a lot worse than Exxon.

In addition to a great record of increasing the dividend, XOM is "cheap" by several metrics, as seen below.

If we look at Exxon's PE for the past 10 years, you can plainly see that shares are currently trading at the bottom of the range. This is obviously bullish as the odds of further multiple compression can reasonably be expected to be quite low. This, of course, doesn't mean the multiple cannot be compressed further, I'm simply positing that at 9 times earnings, that seems unlikely.

One last chart to make a point; take a look at XOM's price over the past 10 years overlaid with trailing 12 months net income. What we see is that there is an extremely high correlation with Exxon's net income and its stock price under "normal" conditions ("normal" being defined as periods other than the financial crisis). This, of course, should exist as companies should be valued upon the amount of money they earn. However, what this also shows is that Exxon's multiple is highly unlikely to expand beyond maybe 10 times earnings in the future. Given that the price and net income are so closely correlated, it can be reasonably expected that this relationship will continue. I point this out because if you notice, Exxon's net income is nearly back to its all-time high in 2008-2009 when oil peaked at $147 per barrel. Again, this means that if you buy Exxon today, you are betting that they are going to eclipse their all-time net income highs in the coming years. This may or may not happen, but I believe the risk is probably that it won't.

Conclusion

If you believe that the price of crude oil is set to rise substantially in 2013, we've proven here that Exxon Mobil is a great way to participate in the action. Conversely, I believe Exxon Mobil shares are probably fairly valued at this point and that the main reason one would buy the shares currently is for the dividend. Capital appreciation will be hard to come by in 2013 unless XOM drops into the mid $70s. If XOM shares do trade into the $70s that would potentially be a great entry point given the dividend and the stability of their business. However, any shareholder must be keenly aware of the risks involved if crude oil prices collapse next year as Exxon Mobil shares will surely collapse as well.

Exxon is a terrific, shareholder friendly company but I believe the shares are probably fairly valued at best, and over-extended at worst. If you must be long XOM, wait for an entry point below $80.

Source: Exxon Mobil: Valuation Discussion