As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Royal Dutch Shell's (RDS.A) case, we think the firm is fairly valued at $86 per share, significantly higher than where it is currently trading.
For some background, 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. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth, hour-long presentation on our methodology with President Brian Nelson). The VBI ranks stocks on a scale from 1 to 10, with 10 being the best. In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Royal Dutch Shell posts a VBI score of 4 on our scale, reflecting our 'fairly valued' DCF assessment (it is trading below our fair value estimate but still within our fair value range), attractive relative valuation versus peers, and bearish techinicals. We use ConcoPhillips (COP), BP (BP), Chevron (CVX), and Exxon Mobil (XOM) for our peer group analysis.
Our Report on Royal Dutch Shell
In the spirit of transparency, our report on Royal Dutch Shell and hundreds of other companies can be found here.
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Royal Dutch Shell 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 12.2% during the past three years.
The firm is trading at attractive valuation mulitples relative to peers, but our DCF process indicates a less compelling opportunity. We prefer companies that are trading below our fair value range.
Royal Dutch Shell's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 0.1% during the past three years, much lower than the mid-singledigit range we'd expect for cash cows. Total debt-to-EBITDA was 0.5 last year, while debt-to-book capitalization stood at 18%.
The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
The firm sports a very nice dividend yield of 4.9%. We expect the firm to pay out about 60% of next year's earnings to shareholders as dividends. We're strongly considering the firm for addition to the portfolio in our Dividend Growth Newsletter.
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 (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Royal Dutch Shell's 3-year historical return on invested capital (without goodwill) is 12.2%, which is above the estimate of its cost of capital of 11.1%. 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. Royal Dutch Shell's free cash flow margin has averaged about 0.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. 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 Royal Dutch Shell, cash flow from operations increased about 71% from levels registered two years ago, while capital expenditures fell about 1% over the same time period.
The estimated fair value of $86 per ADR represents a price-to-earnings (P/E) ratio of about 8.7 times last year's earnings and an implied EV/EBITDA multiple of about 4.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 19.3%. Our model reflects a 5-year projected average operating margin of 12%, which is above Royal Dutch Shell's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For Royal Dutch Shell, we use a 11.1% weighted average cost of capital to discount future free cash flows.
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 $86 per ADR, 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 Royal Dutch Shell. We think the firm is attractive below $68 per ADR (the green line), but quite expensive above $104 per ADR (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.
Future Path of Fair Value
We estimate Royal Dutch Shell's fair value at this point in time to be about $86 per ADR. 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 Royal Dutch Shell's expected equity value per ADR 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 ADRs 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 $105 per ADR in Year 3 represents our existing fair value per ADR of $86 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
Additional disclosure: COP and CVX are included in the portfolio of our Dividend Growth Newsletter.