Devon Energy Corporation (DVN) is one of the largest independent oil and gas companies in the U.S. Founded in 1971. The Oklahoma-headquartered Devon has operations in Rocky Mountains, Mid-Continent, Permian Basin, and Gulf Coast regions in the U.S. The company also holds interests in several oil and gas properties in Alberta, British Columbia, and Saskatchewan provinces of Canada. The company operates about 24,000 wells, and has proven reserves of about 800 million barrel of oil equivalents. It has a strong balance sheet. Each Devon share comes with a cash equivalent of almost $18 per share. However, the stock has been a loser for a year, and its current price is substantially below the analysts target price.
As of the time of writing, Devon stock was trading at $63, with a 52-week range of $51 - $85. It has a market cap of $25.4 billion. Trailing twelve month [ttm] P/E ratio is 11.7, and forward P/E ratio is 9.1. P/B, P/S, and P/CF ratios stand at 1.2, 2.2, and 4.3, respectively. Operating margin is 36.6%, and net profit margin is 39.7%. The company has some minor debt issues. Debt-to-equity ratio is 0.3. Devon pays some dividends. The projected yield is 1.3%.
Devon has a 5-star rating from Morningstar. It is categorized as a large-value company. While its trailing P/E ratio is 11.7, the industry average is 16. Thus, Devon is trading well below the industry average. Out of 6 analysts covering the company, 4 have buy, 1 has outperform, and 1 has hold ratings. Wall Street has diverse opinions on Devon's future. The bottom line is -9.2% growth, whereas the top-line growth estimate is 44.5% for the next year. Average five-year annualized growth forecast estimate is 4%. Related industry peers include Apache Corporation (APA), Anadarko Petroleum (APC), Chesapeake Energy (CHK), and Canadian Natural Resources (CNQ).
What is the fair value of Devon, given the forecast estimates? We can estimate Devon's 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 estimates. You can set these parameters as you wish, according to your own diligence.
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 ttm EPS of $5.23 along with the mean estimate of $6.85 for the next year.
E0 = EPS = ($5.23 + $6.85) / 2 = $6.04
Wall Street holds diversified opinions on Devon'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 4%. Book value per share is $54.29.
The rest is as follows:
Fair Value Estimator
Fair Value Range
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 Devon is between $71 and $125 per share. The current price indicates that the stock is deeply undervalued. Based on my FED+ fair value estimate, Devon has a minimum 15% upside potential to reach the lower-end of its fair-value. Analysts has a target price of around $87, which is somewhere in the middle of my fair-value range.
When evaluating a company, it will be wise to consider where the valuation metrics stand in the industry. In terms of valuation ratios, Chesapeake seems like the cheapest one as the stock has the lowest P/S, P/B, and P/E ratios of 0.9, 0.7, and 5.8. However Chesapeake's balance sheet is not as strong as Devon. Its debt is higher and the company is going through though times. Devon has very similar ratios with that of Canadian Natural Resources and Apache Corporation. Compared to Devon, Apache seems like a cheaper option as it supports a relatively lower trailing P/E ratio of 7.6. Anadarko Petroleum is the only company in this group, which has not reported positive earnings in the last trailing twelve months. Similar to Chesapeake Energy, its debt ratio is comparatively higher.
Canadian Natural Resources
As can be seen from the table above, the independent oil & gas companies did not perform well for a while. In terms of annual performance, Chesapeake was the biggest loser, followed by Apache Corporation, and Canadian Natural Resources. Devon was doing fine at the beginning of this year. The stock made it to as high as $75 in mid-March. However, it could not break this resistance level and retreated back to near $63.
Looking at the price performance graph, one can observe that $60 is a strong support level for Devon Energy. That price level should be watched with caution. I highly doubt the stock can fall below this level. Earnings are expected to increase by almost 30% in the next year, which suggests a single digit P/E ratio for Devon Energy. Unless the commodity prices collapse, a bounce back is very likely.
The independent oil & gas companies are among the cheapest ones in the market. That is mainly due to these companies' substantial exposure to natural gas-related assets. However, I do not think that natural gas prices could go any lower. The market for natural gas has become extremely volatile, but the fundamentals suggest that there should be a balance with resource prices. As more utility companies are switching to natural gas, the increased demand should result in higher natural gas price. The recent spike in natural gas could be a sign of trend reversal. Higher gas prices will surely boost the natural gas related stocks. That might not happen tomorrow, but I am positive for the long-term.