As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Exxon Mobil's (XOM) case, we think the firm is fairly valued at $74 per share. Though this falls within our fair value range, the firm's stock price that is now approaching $90 is getting away from intrinsic value. Remember: price is what one pays for a stock, while value is what the company is worth based on its future free cash flow stream.
We think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. We like firms that fall in the center of the diagram below:
If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Exxon Mobil posts a VBI score of 3 on our scale, reflecting our "fairly valued" DCF assessment of the firm and its unattractive relative valuation versus peers. We compare Exxon Mobil to peers BP (BP), Chevron (CVX), and ConocoPhillips (COP). In the spirit of transparency, we show how our strategy has created outperformance in the portfolio of our newsletter below:
Our Report on Exxon Mobil
• Exxon Mobil's scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 12.8% during the past three years.
• Exxon Mobil's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 4.2% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.
• Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Exxon Mobil's 3-year historical return on invested capital (without goodwill) is 12.8%, which is above the estimate of its cost of capital of 9.3%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Exxon Mobil's free cash flow margin has averaged about 4.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Exxon Mobil, cash flow from operations increased about 95% from levels registered two years ago, while capital expenditures expanded about 38% over the same time period.
Our discounted cash flow model indicates that Exxon Mobil's shares are worth between $58.00 - $90.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $74 per share represents a price-to-earnings (P/E) ratio of about 8.8 times last year's earnings and an implied EV/EBITDA multiple of about 5.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 0.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 0.6%. Our model reflects a 5- year projected average operating margin of 11.7%, which is above Exxon Mobil's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Exxon Mobil, we use a 9.3% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $74 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Exxon Mobil. We think the firm is attractive below $58 per share (the green line), but quite expensive above $90 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion. As one can see, Exxon's price is trading near the high end of the range.
Future Path of Fair Value
We estimate Exxon Mobil's fair value at this point in time to be about $74 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Exxon Mobil's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $91 per share in Year 3 represents our existing fair value per share of $74 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Additional disclosure: Some of the firms mentioned in this article are included in our Dividend Growth portfolio.