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By Cagdas Ozcan

Exxon Mobil (XOM) has followed extremely impressive capital allocation strategies, which has allowed the company to grow well. Thanks to its focus on efficiency, the company has been able to deliver impressive results. We expect energy companies to do well in the next two to three years due to a recovery in the global economy. Energy demand is likely to keep rising in future. As a result, we believe the energy sector represents an attractive opportunity. Exxon Mobil is probably one of the safest investment candidates in the sector. Here we tried to find the fair value of the stock based on our valuation model.

As of the time of writing this article, Exxon's stock was trading at around $90, with a 52-week range of $77.13 - 93.67. It has a market cap of about $405.9 billion. The trailing twelve-month P/E ratio of 9.3 is below the forward P/E ratio of 10.2. P/B, P/S, and P/CF ratios stand at 2.4, 0.9, and 7.4, respectively. The operating margin is 16.3% while the net profit margin is 9.3%.

Exxon Mobil has a 3-star rating from Morningstar. Out of the analysts covering the stock, four have a strong buy recommendation and further four have a buy recommendation. In addition, fifteen analysts have hold recommendations about the stock. Average five-year annualized growth forecast estimate is 0.85%.

We can estimate Exxon Mobil's fair value using discounted earnings plus equity model as follows.

Discounted Earnings plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year. The average EPS for Exxon Mobil is $8.31.

While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 0.85%. Book value per share is $37.65.

Fair Value Estimator

V0

E0

$8.31

V1

E0 (1+g)/(1+r)

$7.55

V2

E0((1+g)/(1+r))2

$6.86

V3

E0((1+g)/(1+r))3

$6.23

V4

E0((1+g)/(1+r))4

$5.66

V5

E0((1+g)/(1+r))5

$5.14

D

E0(1+g)5/[r(1+r)5]

$46.77

BV

Equals

$37.65

Fair Value Range

Lower Boundary

$86.53

Upper Boundary

$124.18

Potential

37.09%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Exxon Mobil is between $86.53 and $124.18 per share. At a price of about $90, Exxon Mobil is trading close to the lower boundary of its fair value range. The stock still has up to 37% upside potential to reach its fair value maximum.

(click to enlarge)

Summary

According to our valuation model, there is substantial upside potential in the stock. Based on long-term earnings growth expectations, the stock is currently undervalued. The recovering global economy should increase the demand for energy, and the energy sector stocks should grow well over the next two years. On the negative side, Exxon Mobil might suffer due to its exposure to natural gas, as natural gas prices are expected to remain low in the near-future. However, potential export of natural gas should give some support to natural gas prices in the domestic market. As a result, Exxon might actually benefit from its exposure to natural gas.

Source: How Much Is Exxon Worth?