Let's try word association. You say: large cap oil and gas. We say: Exxon. Though we prefer Chevron (NYSE:CVX) as our favorite dividend growth idea (you can read why Valuentum's Brian Nelson thinks so here), every investor should become familiar with Exxon's (NYSE:XOM) fundamentals. In this article, let's calculate Exxon's intrinsic value on the basis of its future free cash flow stream and run shares through the Valuentum style of investing.
For those that may not be familiar with our boutique research firm, 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. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas - as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree.
That's why we focus on the DCF - that's why we focus on relative value - and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis 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 Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. This is a fairly strong score for this market environment, and while we generally prefer companies that register higher ratings in the Best Ideas portfolio and Dividend Growth portfolio, Exxon Mobil is still worth a look. Let's continue.
Exxon Mobil's Investment Considerations
• Exxon Mobil 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 14.1% during the past three years. Exxon has 25.2 BOEB of total proved reserves.
• Exxon Mobil is involved in the exploration and production of crude oil/natural gas, and 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.
• We were quite impressed with Exxon Mobil's 2013 performance. Return on capital employed was a solid 17%+, while the company's reserve replacement was north of 100%. The firm's ROCE performance is consistently better than that of its peers, and its upstream earnings-per-barrel trails only that of Chevron in its peer group. It has generated $100+ billion in free cash flow since 2009.
• Exxon has a wonderful streak going. The energy giant has had 20 straight years of more than 100% reserve replacement. We find this to be a remarkable streak given its size and production capacity. The investments that it is making continue to position it for long-term success.
• Exxon Mobil's dividend is solid, and we expect growth in it for many years to come. The energy giant's Valuentum Dividend Cushion ratio is significantly greater than parity. It currently yields 2.7%.
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 with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Exxon Mobil's 3-year historical return on invested capital (without goodwill) is 14.1%, which is above the estimate of its cost of capital of 9.5%. 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. Exxon Mobil's free cash flow margin has averaged about 4% 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 Exxon Mobil, cash flow from operations decreased about 19% from levels registered two years ago, while capital expenditures expanded about 9% over the same time period.
Our discounted cash flow model indicates that Exxon Mobil's shares are worth between $72-$108 each. Shares are trading at just over $100 each at the time of this writing. 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 $90 per share represents a price-to-earnings (P/E) ratio of about 12.2 times last year's earnings and an implied EV/EBITDA multiple of about 4.6 times last year's EBITDA. Investors of Exxon's stock know that it's extremely difficult to catch the firm when it is underpriced. Investors like to bid the company higher on the basis of its quality dividend.
Our valuation of Exxon reflects a roughly a flat revenue growth rate during the next five years, mostly due to the unpredictability of energy prices and expectations for modest revenue declines in the next couple of years. Our model reflects a 5-year projected average operating margin of 14%. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Exxon Mobil, we use a 9.5% weighted average cost of capital to discount future free cash flows. The intermediate-term, long-term growth rate, and discount rate are appropriate for a firm of Exxon's size and business quality.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers - those that drive stock prices - pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Exxon Mobil to peers BP (NYSE:BP) and Chevron, among others.
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 $90 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 $72 per share (the green line), but quite expensive above $108 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.
Note: We've hardly ever witnessed a scenario where Exxon's shares have been underpriced on a discounted cash-flow basis. We think the market is assigning a much lower discount rate than we have modeled, fairly or not. Our views on the discount rate can be found here.
Future Path of Fair Value
We estimate Exxon Mobil's fair value at this point in time to be about $90 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 $111 per share in Year 3 represents our existing fair value per share of $90 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
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: CVX is included in the Dividend Growth portfolio.