Value Hidden In Plain Sight: Chevron

| About: Chevron Corporation (CVX)


We look at companies, and try to see how they are perceived by different stock selection styles adopted by market participants.

We look at companies, and try to see how they are perceived by different capital allocation styles adopted by market participants.

We look at companies, which we believe are good. And we try to determine whether they are trading at a good price.

Through the price-value debate, we seek to determine the growth expectations the market is signaling for the stock. And whether we believe those growth expectations are correct.

Why look at Chevron (NYSE:CVX) now?

Firstly, Chevron is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, the stock has a low beta. This adds to the defensive characteristics and protects downside during weak markets. Thirdly, the stock delivers a yield of 3.5%, which is a significant premium to the market yield. What more, the time for the annual dividend hike fast approaches: a hike to $1.1 per quarter will take the yield to 3.85%. This too adds defensive characteristics to the stock. Fourthly, I believe that we are now either in, or fast approaching the late or mature phase stage of the economic expansion. As I mentioned in a recent post, during such periods, the energy sector has displayed a historic tendency toward outperformance. Finally, Chevron as recently priced, includes potential alpha. Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. When a low beta stock includes potential alpha, downside protection is provided by the low beta, while upside total return potential is not compromised, because we earn returns from alpha in addition to the lower upside beta driven gains associated with low beta stocks.

Analyst price expectations

Recently Chevron traded at $114.10. From Yahoo Finance we know that eighteen analysts expect an average price target of $129.56 (median $130), with a high target of $141 and a low target of $120. We know the price, and we know analyst perception of future price. Does the current price reflect good value?

Quantitative analysis of the behavior of market participants

A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here as that will allow you to appreciate the model output later in this post better. Recently, some of the output of the Alpha Omega Mathematica [AOM] model is being published online, and you can see a list of the top and bottom 20, for large, mid, and small cap stocks here. You can view additional information for any specific stock here. You may find differences between the data displayed below in this post and the data on the website: this is because I run the model for a coverage universe of all stocks listed in US with a market capitalization of over $100 million, whereas the website uses a different coverage universe.

The Dow includes two energy stocks: Exxon Mobile (NYSE:XOM) and Chevron. That system provides an Over-all AOM Score of 27% and a sell rating for Exxon, and an Over-all AOM Score of 47% with a hold rating for Chevron. Let's see why.

Source: MaxKapital Archives using data from Financial Visualizations

The focus is on Chevron in this post, I have covered Exxon in an earlier post. People select stocks to a personal style bias and so we have value, growth, momentum, balanced and agnostic styled investors.

This table below gives you information to help you determine whether your stock selection style bias is satisfied by the stock in question. For Chevron it suggests that valuation is attractive. However market perception of growth and momentum is very negative. The ownership and return quality is acceptable.

Source: MaxKapital Archives

Some investors like to select what they see as the best stock in a sector. Others prefer to select what they see as the best stock in an industry. And there are yet others, who simply want to own what they see as the best stock available, without regard to the sector or industry in which it operates. These are the three main capital allocation styles. For Chevron it is a hold across the board, except for growth and balanced investors, particularly those who are sector and industry agnostic, who would be inclined to sell.

Source: MaxKapital Archives


The stock selection model is a point in time model. And it suggests that the stock is attractively valued. So we might believe that Chevron is attractive. But thus far its attractiveness has been viewed relative to other stocks in its sector, industry, or the coverage universe. We do not know whether the stock is priced to deliver a long-term return in-line with our expectations.

Mathematically, the worth of Chevron is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].

What is our long-term return expectation for a stock with a beta of 1.00, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? This beta of 1.00 differs from the beta that you will find in most places, because it is based on a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge toward one. You can read more about where I get my estimates for long-term market returns and equity risk premium here. The required rate of return is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Chevron, we should be targeting a long-term return of 10.25%. Is the stock priced to deliver that return?

Earnings tend to be volatile from year-to-year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. I believe sustainable earnings can be estimated as the six year median earnings per share. Thus cyclically adjusted earnings per share of $11.38, is an estimate of sustainable earnings for Chevron.

The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. I expect Chevron will payout approximately 33.67% of earnings via dividends and buybacks (about 28% via dividends and another 5% to 6% via buybacks) over the long-term.

If we use a very long-term growth expectation of 6.67%, Chevron is worth $114.10. Chevron Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.67% * $11.38 * 33.67% / (10.25%-6.67%) = $114.10. At this price it is likely that an investor with a return expectation of 10.25% will be satisfied.

The growth estimate implied by the current market price of 6.67% is low. In my view, given Chevron's significant capital expenses over the past few years, it can be expected to grow at a faster rate: in forward years, I would look for nominal growth of 7.5%. That is 2.5% in production growth, plus price growth driven by global inflation rates estimated at 3.8%, and a little bit more on pricing gains driven by supply constraints and rising marginal costs of new production. If I am right, the spread between the 6.67% growth priced by markets, and a 7.5% growth expectation, is 0.83%: this represents potential long-term alpha. An adjusted payout ratio of 33.67% implies that 66.37% is available for investment in operating expenditure and capital expenditure to drive growth. Generating growth at 7.5% would require a return on equity of 11.31%: that is an easily achievable target. Alpha is the difference between actual returns and the risk adjusted return expectation. Since we have a risk adjusted return expectation of 10.25% for Chevron, a long-term investor targeting a risk adjusted return of 10.25% will end up earning a return of 11.08%.

An investor with a shorter time horizon might do quite well too. A price target of $141 implies confidence in long-term earnings growth rising to 7.33% from 6.67% at present. Chevron Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 107.33% * $11.38 * 33.67% / (10.25%-7.33%) = $141.

The formula above helps to compute a fair value for a stock. It is simple, and you can use it to calculate a value based on your expectations, as opposed to mine. But if you do so, be cautious.

If you alter your risk free rate assumptions, you will need to evaluate how that will impact market return expectations, and the equity risk premium too. You will also need to think about how the risk free rates will impact long-term growth. If you alter the adjusted pay-out assumptions, think about how that might impact the growth assumption and the capital structure. For instance, higher growth may signal a need for fresh equity or debt. And if the capital structure changes, so will beta. When you alter growth assumptions, think about how it might change the operational mix, and the impact that might have on the stocks beta, and stock return expectations.

There is a high degree of inter-connectivity between beta, growth, adjusted pay-out ratio's, risk free rates, and market and stock return expectations. And reading the inter-connectivity wrong will result in an answer that ranges from absurd to obscene: this model comes with warts. To avoid falling into this trap, here are some ideas which I hope will help.

1. Since valuation is about what you are willing to pay for a stock, perhaps the most important consideration is the growth risk premium: that is Long-term Return Expectation minus Long-term Growth Rate. The question to ask yourself is that if you expect a stock to grow at a certain rate, how much over and above that growth would you want by way of a stock return expectation, to compensate you for the risk that the long-term growth rate might not be in line with your expectations. This spread will be low for a fast growing stock, where there is great confidence in forward growth expectations. And higher for stocks where the confidence in growth is low. In the very-long term, the growth risk premium has tended towards 4.5% for the market.

2. When you look at sustainable earnings for a growth stock, you need to look at where you expect earnings to be a few years down the road. And then discount that number to its present value using your stock return expectations to obtain today's sustainable earnings

3. When you look at long-term growth rates, remember it is not next year's growth, or the next five year's growth you are looking for. You are looking for a composite long-term growth rate expected over the life of the company. This will be made up of foreseeable growth rate for some years, reversion to market growth rates, and finally a terminal growth rate. The terminal growth rate used by many is the risk free rate. I tend to use the very long-term market growth rates, since if the terminal growth rate is below market growth rates, I as an investor have the option to exit and enter the broad market. The life-expectancy of a typical Fortune 500 company is 40 to 50 years: you can read more about this here. So we can consider using a five year forward rate, and then assume growth shall revert to being in-line with market growth expectations for the following 45 years. What this signals is that I am willing to pay a premium for currently foreseeable growth expectations, but after that period, I expect to share fully in the reward of growth over market growth rates. On excel you can calculate a composite growth rate for a company growing at 15% per year for five years, followed by growth at 8% for the following 45 years as 8.68% [=POWER(1/1*115%^5*108%^45,1/50)-1].

4. Test your adjusted payout expectations. Take your growth rate and divide it by 1 minus the pay-out ratio. The result will estimate the return on equity implied in the model for the company. Review the return on equity to see if it is broadly consistent with the return on equity for the industry over the long-term. If it is high, review the return on equity in the context of the leverage employed by the company. A levered company will have a higher return on equity, and so a high return on equity for a company may be perfectly justifiable in some circumstances. However, higher than industry leverage implies higher financial risk. Which implies a higher beta, and a market return expectation. If you see a low beta with higher than industry leverage, you may want to compute a bottom up beta for the company, instead of one generated using regression analysis.

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.