The Correct Way To Think About Exxon Mobil's Valuation

| About: Exxon Mobil (XOM)


Exxon Mobil's dividend is solid, and we expect growth in it for many years to come. The energy giant's valuentum dividend cushion score is significantly greater than parity.

Return on invested capital at Exxon Mobil has been fantastic, and the company has been consistently replacing its reserves.

We think a wide range of probable fair value outcomes is appropriate in Exxon Mobil's valuation given the inherent volatility of future oil prices.

One of the reasons our members love us is that we tell the story through the numbers. Every income statement says something, every balance sheet has a history and every cash flow statement reveals a firm's true intrinsic value. The numbers talk--and we think every investor should listen to them. Let's see what they say about Exxon Mobil (NYSE:XOM).

But first, a little background to help with the understanding of this piece. 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.

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). At first, this may sound strange, but we think it is genius in its simplicity. By focusing on what drives stock price movement, namely valuation and technical/momentum analysis, we position our members to identify the stocks that are most likely to appreciate. Said differently, all investors are interested in stocks that go up. We think those stocks are ones that are underpriced and are just starting to get noticed by the investment community as being so. More interest in the shares by various investment methodologies --> more buying in shares --> greater likelihood of price-to-fair value convergence. Though we show our work like all good students do, it doesn't get more simple than that.

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. Exxon Mobil posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and very bearish technicals. But don't panic. Exxon is a fantastic company, with a solid dividend. For relative valuation purposes, we compare Exxon Mobil to peers ConocoPhillips (NYSE:COP), Chevron (NYSE:CVX), and BP (NYSE:BP). Relative valuation assessments have their shortcomings, but we also perform an in-depth discounted cash flow process. All of our fair value estimates are derived by the unique expected future free cash flows of firms. There's no other way to determine intrinsic worth, in our view.

Our Report on Exxon Mobil

Exxon Mobil's Investment Considerations

Exxon Mobil's Investment Highlights

• Exxon Mobil's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very

• Exxon Mobil is involved in the exploration and production of crude oil/natural gas, the manufacture of petroleum products as well as the transportation and sale of crude oil, natural gas and petroleum products. It also makes commodity petrochemicals.

• Exxon Mobil has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 6.2% in coming years. Total debt-to-EBITDA was 0.1 last year, while debt-to-book capitalization
stood at 6.5%.

• We were quite impressed with Exxon Mobil's 2012 performance. Return on capital employed surpassed 25%, while the company's reserve replacement hit 115%. The ROCE number was the best among peers, and the firm has been consistently replacing reserves.

• Exxon Mobil's dividend is solid, and we expect growth in it for many years to come. The energy giant's Valuentum Dividend Cushion score is significantly greater than parity.

Exxon Mobil's Business Quality

Exxon Mobil's 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. Please note that our calculation of ROIC is slightly different than the firm's calculation of return on capital employed (ROCE). Exxon Mobil's 3-year historical return on invested capital (without goodwill) is 15.1%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. 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.

Exxon Mobil's 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 5.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. 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 At Exxon Mobil, cash flow from operations increased about 16% from levels registered two years ago, while capital expenditures expanded about 28% over the same time period.

Exxon Mobil's Valuation Analysis

Our discounted cash flow model indicates that Exxon Mobil's shares are worth between $75-$113 each. We think the most valuable research providers out there on the web are ones that acknowledge two things. One: all value is based on the future. And two: the future is inherently unpredictable. Once these two very basic concepts are embraced, the only correct answer is the application of a fair value range and a margin of safety around a fair value estimate. 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. Though Exxon Mobil's risk rating is lower than one might expect in the highly-volatile energy space, we think it is appropriate given the stability of its performance in recent years. That said, however, a wide range of probable fair value outcomes is still appropriate given the inherent volatility of future oil prices.

The estimated fair value of $94 per share represents a price-to-earnings (P/E) ratio of about 9.7 times last year's earnings and an implied EV/EBITDA multiple of about 4.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -1.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 15.8%. Our model reflects a 5- year projected average operating margin of 15%, 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 3.6% for the next 15 years and 3% in perpetuity. For Exxon Mobil, we use a 9.7% weighted average cost of capital to discount future free cash flows. We think are assumptions, while bigger picture, are quite reasonable.

Exxon Mobil's 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 $94 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 Exxon Mobil. We think the firm is attractive below $75 per share (the green line), but quite expensive above $113 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.

Exxon Mobil's Future Path of Fair Value

We estimate Exxon Mobil's fair value at this point in time to be about $94 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 $115 per share in Year 3 represents our existing fair value per share of $94 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.

Exxon Mobil's Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: CVX is a holding in the Dividend Growth portfolio.