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Established in 1887, Houston-headquartered Marathon Oil Company (NYSE:MRO) is one of the largest independent energy companies in the world. Formerly known as USX Corporation, the company changed its name to its current form in July 2001. The Marathon Petroleum Corporation (NYSE:MPC) was also a part of Marathon Oil until July 2011. Since then, the two companies were separated. Marathon Petroleum is primarily engaged in the refinery business, whereas Marathon Oil operates as a diversified oil company. Marathon Oil's business dimensions are classified into three segments: Exploration and Production, Oil Sands Mining, and Integrated Gas. The company has significant presence in each of these segments. The stock has also done pretty well, returning near 20% in a year.

As of the time of writing, Marathon Oil stock was trading at $30 with a 52-week range of $19 - $35. It has a market cap of $21.3 billion. Trailing twelve month [ttm] P/E ratio is 7, and forward P/E ratio is 8.3. P/B, P/S, and P/CF ratios stand at 1.3, 0.3, and 2.6, respectively. Operating margin is 7.3%, and net profit margin is 4.1%. The company does not have any significant debt issues. Debt/equity ratio is 0.3. Marathon Oil is an okay dividend payer. Current yield is 2% with a payout ratio of 34%.

Marathon Oil has a 4-star rating from Morningstar. Out of 16 analysts covering the company, eight have a buy rating, one has outperform, and seven have hold ratings. Wall Street has diverse opinions on Marathon Oil's future. Top line growth estimate is 1%, and the bottom line growth estimate is -20% for the next year. Average five-year annualized growth forecast estimate is 8.4%.

What is the fair value of Marathon Oil given the forecast estimates? We can estimate the fair value using discounted earnings plus equity model as follows.

Discounted Earnings Plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.

E0 = EPS = ($4.34 + $3.65) / 2 = $3.99

Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 8.4%. Book value per share is $23.80.

The rest is as follows:

Fair Value Estimator

V (t=0)

E0

$3.99

V (t=1)

E0 (1+g)/(1+r)

$3.90

V (t=2)

E0((1+g)/(1+r))2

$3.81

V (t=3)

E0((1+g)/(1+r))3

$3.72

V (t=4)

E0((1+g)/(1+r))4

$3.63

V (t=5)

E0((1+g)/(1+r))5

$3.55

Disposal Value

E0(1+g)5/[r(1+r)5]

$32.25

Book Value

BV

$23.79

Fair Value Range

Lower Boundary

$54.86

Upper Boundary

$78.65

Minimum Potential

80%

Maximum Potential

158%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Marathon Oil is between $55 and $78 per share. At a price of $30, Marathon Oil is at least 80% undervalued.

Click chart to enlarge:

Summary

Marathon Oil was subject to a massive sell-off in the 2011 third quarter. Between July and October, the stock literally crashed from $35 to $19, losing near 45% of its market cap. Since then, there has been a strong recovery, and the stock is steadily moving in its upward trend. The current price is 60% above the stock's 52-week low, but the stock is still trading 12% below its 52-week high.

Oil stocks have a tendency to be undervalued, and Marathon Oil Company is no exception. The stock is trading at single digit P/E ratios. It is also priced at only 6.7 times the free cash flow. The balance sheet shows around $6.5 per share of cash and equivalents. Thus, the dividends have a high margin of safety.

Based on my FED+ valuation, Marathon Oil is trading at least 80% below its fair value range. The stock has an O-Metrix score of 6.75, which is well above the market average. I think Marathon Oil is likely to hit new highs in 2012. Therefore, I rate it as a buy for 2012. The current price offers a compelling entry point for those interested.

Source: Marathon Oil Has At Least 80% Upside Potential