Earn 6.7% On Cash With A Decent Chance To Buy Exxon Mobil Under $60

| About: Exxon Mobil (XOM)

Summary

How I value Exxon Mobil and why.

The strategy of selling out-of-the-money puts on great companies to earn good yield on extra cash.

How this strategy could allow me to own shares of Exxon Mobil at $58.50 per share and lock in a yield of five percent on a dividend aristocrat.

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Introduction

I like Exxon Mobil (NYSE:XOM) as a long-term investment, but would prefer to buy shares at a price that I believe better represents a fair value during a period of expected low energy prices for more than a year. If readers would like to understand my views on the price of oil please refer to one of my previous articles, "How Low Can Oil Go?" or "Energy Sector Outlook." In those articles, I explain why I expect the price of oil to fall further and remain low (below $40) for the next year or more. And, for that reason, I want to pay less for additional shares of XOM in the current environment.

Valuing XOM my way

I use a very simple method of valuing dividend paying companies. I invest primarily for income so I used the Dividend Discount Model [DDM]. I use the historical average price earnings ratio [P/E] as a check. I also look at how the share price of a company reacted during the last recession to provide a better sense of the potential downside.

One of the main reasons I like the DDM is that it requires only one assumption. The more assumptions a valuation model requires means there is more potential for human error. The DDM requires me to make an assumption about the long-term rate of annual dividend increases. It also requires me to use a required rate of return. That is all I need to run the model. I assign my own required rate of return for each industry down to each stock in which I am interested. My return requirement varies based upon such things as my expected level of risk as well as the growth potential of each company. For XOM, I require a 12 percent annualized rate of return. For other companies in the oil industry with higher debt or a less resilient share price exhibited over history, I may require as much as a 15 percent return.

In order to determine my expected rate of long-term annual dividend growth, I look at the historical averages over 20 years, ten years, five years and one year. Then I do what all great analysts must do in the end: I guess. I know that does not seem scientific enough for most investors, but even when an analyst uses a great predictive model to come up with his/her final expectation, they had to use assumptions for inputs into the model. Each assumption is essentially a guess, educated to be sure, but still a guess. I like to use the historical data as a guide and then adjust according to what I really think will happen.

For XOM I know that the rate of dividend growth is likely to be less than it has been over the past five to ten years. But, when I include the compounded average annual rate for over 20 years I also know that this number takes in some good years and some bad years. It gives me more confidence of what to expect over the longer term. Below is a table that includes those compounded average annual increases to dividends over the last 20, ten, five and one year along with my expectation for the next 20-year period. It also includes the current dividend, my required return and the DDM valuation and the yield at my target valuation price.

Beginning Dividend

Current Dividend

Ave. % Growth

Required Return

DDM Fair Value

Yield @ Fair Value

20 years

$0.75

$2.92

7%

10 years

$1.16

$2.92

10%

5 years

$1.76

$2.92

11%

1 year

$2.76

$2.92

6%

Expectation

$2.92

7%

12%

$58.40

5.0%

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As you can see, I want a price that is about 21% below the current level. When the environment gets really tough even the mighty will fall. To check whether my expectation is realistic or not I use the average P/E ratio. The current P/E ratio is 15.6 while the average P/E ratio over the last 15 years has been 13.4. The high P/E ratio over that time has been 23.4 and the low was 9.5. Earnings are going to fall in 2016 so the P/E will likely rise. But if I use the trailing twelve month [ttm] earnings and apply the average P/E, I get a value of $63.16. If I remove the one highest P/E ratio and recalculate the average over 14 years, the average drops to 12.6. I do that because it was more of an outlier than the lowest P/E, as all but three of the remaining average annual P/E ratios were between 9.5 and 14.1. Then, using the average P/E of 12.6 multiplied by the ttm the resulting fair value becomes $59.77.

When viewed within the above parameters, a goal of a price below $60 seems very realistic to me. After all, the luster of owning oil stocks seems to be losing some luster and when that happens prices usually do not go higher.

As a final check, I looked at what happened to the price of XOM shares during the melt down of 2008-09. Shares fell as low as $55.94 during a very temporary drop in oil prices. I believe that as more investors realize that the current low price is not temporary in nature, we will see some more downside pressure to XOM shares. Again, this adds more support to my expectation that the price of XOM could get down as low as my target price and possibly lower.

XOM Chart

XOM data by YCharts

I have a very long time horizon and intend to hold forever unless the reason I bought the company in the first place changes. I know oil will be replaced eventually but expect that to happen long into the future. So, I like my prospects with XOM over the next ten years or more. If I were a trader rather than an investor I would need far greater precision in my valuation model. I would also probably make far more errors due to the multiple assumptions I would need to make in attempting to achieve that level of precision. The DDM suits me.

I should mention that my fair value may not be yours. If you have a different required return, your fair value will be different from mine. An investor who requires a ten percent return would assign a fair value of $97 to XOM. One that requires a 15 percent return would find fair value to be only $36.50. The DDM is predicated on the principle that price may fluctuate but will eventually follow the dividend yield. My experience has proven this principle works well over the long term; over the short term it may be less reliable.

My Plan to earn income from my cash while I wait patiently for the price to fall

Even if the price falls below my target of $58.40 I would not mind owning XOM shares at that price. I would be starting off with a yield of five percent and would expect that yield to rise over time, on average, at a rate of about seven percent a year. Eventually, I would expect the share price to follow the dividends higher, but probably not until we see the price of oil stabilize above $45 per barrel. I am retired and I have time to wait. Patience is one of the keys to successful investing.

I plan to sell a put option on XOM that expires in January, 2017, with a strike of $62.50. The current premium bid on that contract is $4.00 (at the close on Monday, January 25, 2016). When I sell the contract I will collect the $4.00 per share, or $400 less commissions, and if the share price of XOM is at or below that price at expiration I will put the stock at $62.50 and have a cost basis of $58.50 ($62.50 - $4.00 = $58.50). If the stock never falls that far or if it does but rebounds before January, 2017, I will just keep the $400 earning a yield on my cash used to secure the put of about 6.66 percent. The calculation assumes that I need $6,250 in my account to secure the put, less the $400 premium I collected. In other words, I only need $5,850 of cash in my account to add to the premium collected to have $6,250. So I am using only $5,850 of my own money to secure the option. Assuming a commission for one contract is $10 my gain is $390 so, $390 / $5,850 = 6.66 percent. I can live with that yield when it comes with the potential of buying a stock I want to own at the price I want to pay. If I do not get the stock I still received a decent yield and I did not need to ride the stock down another 21 percent from the current price for the privilege of ownership in uncertain times.

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

For those interested in learning more about my investment philosophy you can find more detail in a series of articles titled, "How I created my own portfolio over a lifetime." For those who prefer to listen rather than read, I was interviewed by Brian Bain, of Investor in the Family, about my investment philosophy and you can listen to the podcast here.

Disclosure: I am/we are long XOM.

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.