The most important question investors should ask themselves about a holding in their portfolio is: What is this company worth? After all, that's what investing is all about. Are you getting a bargain for the stock or not? That's where valuation firms come in. Let's dig into what Chevron's (CVX) is worth in this article.
But first, a little background to help explain our process. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Makes sense? Pretty easy, right? Okay, let's dig in!
Our Report on Chevron
• Chevron 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 14.6% during the past three years.
• Chevron is engaged in integrated petroleum operations, chemicals operations, mining activities, power generation and energy services. The upstream and downstream activities of the company are widely dispersed geographically, with operations all over the globe
• On an indexed basis (2007) Chevron tops peers BP (BP), Royal Dutch Shell (RDS), Total (TOT), and Exxon (XOM) as it relates to average capital employed. Against the same peer group, the firm's adjusted return on capital employed has been consistently second (beyond Exxon). Cash flow per share has been at the top of its peer group, however.
• We're huge fans of Chevron's net cash position. Its primary competitors all boast a net debt position. We think a strong balance sheet is crucial in a commodity-producing business to withstand cyclical troughs.
• Chevron's dividend safety and growth potential are top notch, and the firm is well-positioned to capture future global energy demand, which is expected to advance 40% by 2040.
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 (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Chevron's 3-year historical return on invested capital (without goodwill) is 14.6%, which is above the estimate of its cost of capital of 11.4%. 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 estimate.
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. Chevron's free cash flow margin has averaged about 4.9% 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 Chevron, cash flow from operations increased about 24% from levels registered two years ago, while capital expenditures expanded about 58% over the same time period.
Our discounted cash flow model indicates that Chevron's shares are worth between $80.00 and $120.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $100 per share represents a price-to earnings (P/E) ratio of about 7.4 times last year's earnings and an implied EV/EBITDA multiple of about 3.5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 2.9% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 12.1%. Our model reflects a 5-year projected average operating margin of 15.6%, which is above Chevron's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.3% for the next 15 years and 3% in perpetuity. For Chevron, we use a 11.4% 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 $100 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 was 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 Chevron. We think the firm is attractive below $80 per share (the green line), but quite expensive above $120 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.
Future Path of Fair Value
We estimate Chevron's fair value at this point in time to be about $100 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 Chevron'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 $127 per share in Year 3 represents our existing fair value per share of $100 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: CVX is included in the portfolio of our DG Newsletter. Valuentum updates its fair value estimates frequently, and published fair value estimates on Seeking Alpha may differ than actual fair value estimates on Valuentum's website.