Chevron (NYSE:CVX) has a lot of positive things going for it. However, we think management has dropped the ball a bit when it comes to preserving its net cash position. As investors focused on the long term, a pristine net-cash rich balance sheet was quite alluring to us. Though we still like Chevron quite a bit, the firm has lost a bit of its luster (see here). However, let's dig into how we estimate the energy giant's intrinsic value.
But first, a little background. 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 (timeliness) 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. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). We like to keep things simple. Higher interest in a firm on the basis of an investor's methodology --> more buying in the stock --> greater likelihood of price-to-fair value convergence. We fully accept that the market prices are driven by buying and selling decisions.
(click to enlarge)
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. Chevron posts a VBI score of 4 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technicals. We compare Chevron to peers BP (NYSE:BP), ConocoPhillips (NYSE:COP), and Exxon Mobil (NYSE:XOM). We use these comparisons for relative value purposes. A discounted cash-flow based process, which we use to derive a company's fair value estimate, is our primary valuation tool because it applies characteristic unique to the firm. Relative valuation measures have limitations.
Our Report on Chevron
Chevron's Investment Considerations
Chevron's Investment Highlights
• 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, Royal Dutch Shell, Total, and Exxon 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 like Chevron's balance sheet, but its net cash position has deteriorated. Its primary competitors all boast a net debt position, however. 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. Chevron boasts a very high score on the Valuentum Dividend Cushion, our dividend growth methodology. Please click here for our in-depth take on the company's dividend.
Chevron's Business Quality
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. 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 11.3%. 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 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 $90.00 and $136.00 each (the midpoint is our fair value estimate of the company). This is a wide range that is largely a result of the volatility of its end market prices. Please click here to learn more about how we think about forecasting within our discounted cash-flow model. 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 $113 per share represents a price-to-earnings (P/E) ratio of about 8.4 times last year's earnings and an implied EV/EBITDA multiple of about 4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 0.5% 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 17%, which is above Chevron's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.8% for the next 15 years and 3% in perpetuity. For Chevron, we use an 11.3% 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 $113 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 $90 per share (the green line), but quite expensive above $136 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 $113 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 $143 per share in Year 3 represents our existing fair value per share of $113 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 Dividend Growth portfolio.