How To Potentially Earn A 9.4% Yield On ExxonMobil's Overvalued Shares

| About: Exxon Mobil (XOM)

Summary

ExxonMobil's strong rally since oil hit its mid-February low means that shares are currently overvalued, despite the modest recent pullback.

Declining earnings mean that its investment thesis as a dividend growth stock continues to weaken.

Fortunately, there are two low-risk, margin-free option strategies you can use to buy shares at below fair value, or, should shares stay overvalued, earn a yield of 9.4%.

But there are several risks and details you need to consider before using either strategy.

Click to enlarge

Source: ExxonMobil

ExxonMobil (NYSE:XOM), like most oil stocks, has rallied strongly off its mid-February lows, when crude hit a 13-year low of $26/barrel.

XOM Chart XOM data by YCharts

However, Exxon just reported extremely weak second quarter earnings that potentially bode poorly for its future dividend growth potential. And with crude prices crashing yet again, investors may be wondering whether or not Exxon is worth buying today. Read on to find out why this dividend aristocrat is likely still overvalued. But more importantly, how you can use two low-risk option strategies to either nab shares at below their intrinsic value, or generate strong income should shares remain stubbornly high.

What's Exxon worth today?

Sources: Yahoo Finance, Fastgraphs
Yield 5 Year Average Yield P/OE 20 Year Average P/OE P/OCF 20 Year P/OCF Average Historic Premium
3.5% 2.8% 26.9 15.6 12.5 10.8 21.0%
Click to enlarge

As you can see, while Exxon's yield is nicely higher than its five-year average, on a price to operating earnings, and operating cash flow basis, the stock remains overvalued by around 21%.

Of course, such historical comparisons don't necessarily tell us what's a good price for long-term dividend investors to buy at, since it doesn't take into account the company's future growth prospects.

Source: Morningstar
Morningstar Fair Value Estimate Current Share Price Premium to Fair Value
$79 $85.86 8.7%
Click to enlarge

Which is why I find Morningstar's fair value estimates so useful. While it's true that no single analyst valuation should be taken as gospel or used as your sole basis for investment decisions, nonetheless I view Morningstar's valuation method as the gold standard for determining long-term intrinsic value.

That's because, unlike Wall Street analyst one-year price targets, Morningstar uses a two-stage discounted cash flow model that is based on conservative, and realistic long-term forecasts of a company's fundamentals.

In this case, analyst Allen Good thinks Exxon is around nine percent overvalued relative to its five-year intrinsic value. That valuation assumes an extremely conservative, i.e., bearish, outlook for long-term energy prices, based on current NYMEX futures contract curves.

Source: Morningstar
Year Average Natural Gas Price (per thousand cubic feet) Average Oil Price Per Barrel
2016 $2.13 $39
2017 $2.79 $45
2018 $2.83 $53
2019 NA $70
Long-term $3.00 $60
Click to enlarge

When it comes to dividend investing in energy companies, erring on the side of caution is a good idea, which is why I'm inclined to agree with Mr. Good's valuation. That's especially true since it takes into account fundamental factor forecasts based on the latest management guidance, as well as reports from industry experts, and the US Energy Information Administration, or EIA: specifically, I mean a 2020 production of around 4.1 million bpd of oil equivalent, a cash flow break even price of $40/barrel, and a 7.0% cost of equity.

Click to enlarge

Source: ExxonMobil investor presentation.

XOM Return on Equity (<a href= XOM Return on Equity (NYSE:TTM) data by YCharts

Given that: Exxon currently has over 100 growth projects coming online over the next three years, and has historically been able to leverage its massive vertically integrated business model into superior returns on shareholder capital compared to its peers, I'm confident that investors that end up buying Exxon at $79 will likely end up doing well in the long-term.

Of course, the trouble is that the stock market is incredibly volatile and no one can predict whether or not Exxon will fall that low anytime soon. Which is where the following two option strategies come in. Not only can they potentially help you buy shares of the best vertically integrated oil major on the cheap, but they can also help generate impressive incomen -- even if Exxon stays overvalued.

Cash-secured puts: making overvalued shares work for you

A put is an option contract that gives the owner the option to sell 100 shares of a stock to the writer of the put, i.e., you, at a specified strike price by a certain expiration date. It's primarily a form of insurance against the stock falling in price, and just like an insurance company, you receive the insurance premium up front. If the stock stays above the strike price by expiration, then the contract expires worthless and you keep the premium.

Put writing can be used by two kinds of dividend investors. Those who like an underlying company and want to buy shares at a cheaper price, or investors who don't mind owning shares for the long term but mainly want to generate income.

Source: Yahoo Finance
Put Contract Premium/Share Implied Cost Basis Yield-On-Cost Premium Yield Annualized Premium Yield
Sep 16 $80 $0.76 $79.24 3.8% 0.96% 8.7%
Oct 16 $80 $1.31 $78.69 3.8% 1.66% 8.7%
Jan 17 $80 $3.12 $76.88 3.9% 4.06% 9.4%
Click to enlarge

In this case, the strategy I'm recommending involves selling out of the money puts with a strike price of $80. This results in an effective cost basis of close to the Morningstar estimated fair value of $79. And as you can see, the January 2017 $80 put's annualized premium yield of 9.4% offers the most attractive return, especially given the low risk nature of this strategy, and today's record low interest rates.

In fact, pretty much the only other asset that is offering similar yields today is distressed corporate debt, i.e., junk bonds. I don't know about you, but I'd much rather generate high-yield with a strategy based around a rock solid blue chip like Exxon, whose credit rating is AA+.

The longer the duration of the contract the higher the premium, due to more time value. However, while you can potentially write a put with a duration of 2 years, I wouldn't recommend going out more than six months because of the volatile nature of the energy industry.

Specifically, if oil prices end up recovering strongly over the next two years, then Exxon's intrinsic value could soar along with them. Two to six month contracts provide a good balance of high premium and limited duration, at which point we can reassess Exxon's intrinsic value as more company and energy data become available.

Bull Put spreads: income generation but with insurance against a potential mega crash

Source: Yahoo Finance
Bull Put Spread Net Premium/Share Implied Cost Basis Yield-On-Cost Premium Yield Annualized Premium Yield
Sep 16 $80/$75 $0.49 $79.51 3.8% 0.62% 5.5%
Oct 16 $80/$75 $0.72 $79.28 3.8% 0.91% 4.8%
Jan 17 $80/$75 $1.11 $78.89 3.8% 1.41% 3.2%
Click to enlarge

An even more conservative option writing strategy is called a bull put spread. This involves hedging against the share price of a stock falling off a cliff, which would leave you holding shares at a potentially substantial unrealized loss.

The way this works is that you write a put contract to earn premium, and also buy a lower priced, i.e., more out of the money, contract, which is less expensive. This still generates a net premium, and can still generate a decent, if somewhat smaller, income source. For example, selling a September 2016 $80 put, and buying a September $75 put, pays an annualized yield of 5.5%, and results in an effective cost basis of $79.51.

Why exactly might you want to use this strategy, since it results in a 3.2% lower annual yield than simply selling the September $80 put?

Yahoo Finance
Bull Put Spread Max Loss/Share Min Value of $70 Put (XOM @ $65) New Implied Cost Basis New Yield-On-Cost Unrealized Loss (Unhedged) Unrealized Loss (Hedged)
Sep 16 $80/$75 $4.51 $10.49 $69.51 4.3% 18.2% 6.5%
Oct 16 $80/$75 $4.28 $10.72 $69.28 4.3% 18.0% 6.2%
Jan 17 $80/$75 $3.89 $11.11 $68.89 4.4% 17.6% 5.6%
Click to enlarge

Let's say that oil prices continue to crash and Exxon falls to $65 by September 16, the option's expiration date. If you hadn't hedged against such a scenario, then you'd receive 100 shares of Exxon per contract at an effective price of $79.24, and be looking at an unrealized loss of 18.2%.

But because you bought insurance in the form of the September $75 put you now have two options. First, if you fear that oil prices, and thus Exxon shares will continue falling, you can always exercise the put and sell your shares at an effective price of $75.49, which is the strike price + net premium. That limits your maximum loss to just $4.51/share or 5.7%.

But, and this is the route I would advise since you shouldn't be writing this spread unless you want to own Exxon for the long-term, you can also choose to keep the shares, and sell the put, which has an intrinsic value of $10, ($75 strike price - current $65 share price). Combined with the $0.49 in net premium you received for writing this spread, your new effective cost basis becomes $80-$10.49 or $69.51. Not only does that mean your shares have a highly attractive yield on cost of 4.3%, but your unrealized loss is only 6.5%, instead of 18.2% had you simply written the $80 put.

Risks to consider

While cash-secured puts are one of the more conservative options strategies you can use, nonetheless there are several risks and details that investors need to consider before using the two strategies discussed here.

First, and I can't stress this enough, ONLY write Exxon puts if you are willing to own the company for the long-term. After all, anything less is just speculating on oil prices, and as we've seen over the past two years, no one can accurately predict what crude and gas prices will do in the short-term.

Speaking of speculation, make sure that you only write puts if you have sufficient capital to actually buy the shares your contracts potentially obligate you to buy. Most brokers will allow you to trade options on margin, meaning that it's possible to write naked puts --selling contracts without sufficient cash to buy the shares.

This strategy utilizes leverage, which while potentially resulting in even higher premium yields, also exposes your portfolio to the risk of a margin call in case Exxon's share price moves against you too violently. That in turn can result in you either having to add cash to your account quickly, or face the prospect of your broker automatically selling positions in order to meet your margin requirements. If that occurs you become a price insensitive, forced seller, which is something that you need to avoid at all costs.

That's because in the event that Exxon's price collapse coincides with a broader market correction, a margin call can result in you selling large amounts of other holdings at the worst possible time. That can lock in potentially massive losses that result in permanent losses of capital. And as Warren Buffett famously said about the two most important rules to successful long-term investing: "Rule #1: Never lose money. Rule #2: Never forget rule #1."

Also, you need to understand that, in addition to potentially facing unrealized losses if shares are put to you, put writing also exposes you to opportunity cost risk. For example, let's say that Exxon shares fall below $80 in the months ahead, but then rebound above this level before the contract expiration date.

In that case the contracts will expire worthless and you get to keep the premium. But you'll also potentially forgo an opportunity to buy attractively priced shares, which may end up rallying strongly should crude prices recover more strongly than expected in the years to come.

Next is the issue of costs. The examples I used didn't include commission costs for the sake of simplicity. However, in real life you ALWAYS need to factor in trading costs. That's because option commissions can vary wildly by broker: from just $0.70 per contract with a $1 minimum for Interactive Brokers (NASDAQ:IBKR), to $12.95 for the first 10 contracts and then $1.25 per contract after that at Options Xpress.

If you can only afford to cover one or two contracts then these commissions can end up eating much of your option premium, potentially making the entire strategy not worth pursing. For example, say you wrote a single September $80/$75 spread, which pays a net premium of $49, at Options Xpress. The $12.95 commission will ending up eating 27% of your premium, an outrageous commission that greatly weakens the potential risk/reward ratio.

On the other hand, say you can afford to buy 1000 shares of Exxon, trade with eOption which charges $3.0 + $.15/contract, and want to write 10 Jan 17 $80 puts, which would pay $3,120 in premium. In that case your $4.50 commission represents a trading cost of just 0.14%, which is basically a rounding error. In other words, put writing is best used by wealthier investors with sufficient capital to achieve these kinds of economies of scale.

And finally, you can't forget one of the only two certainties in life: death and taxes. Uncle Sam is going to insist on getting a cut of your premiums, and no matter how long a contract you write, all written option premium is taxed as short-term capital gains. That means at your marginal tax rate, which can be as high as 39.6%.

Bottom line: Conservative option writing is a great way to profit from Exxon, no matter which way the share price moves

Don't get me wrong, I'm not saying that options are the right strategy for all investors. However, if you're like me and bullish on Exxon's long-term prospects, and keep the risks and details above in mind, then put writing can be an excellent way to either earn a generous income premium, or buy shares at a much better price -- one that's better aligned with the company's intrinsic value given potentially much lower energy prices in the years ahead.

Disclosure: I/we 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.