As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Exxon Mobil's (XOM) case, we think the firm is fairly valued at $80 per share, near 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. Our process remains consistent with the significant outperformance of a 50/50 long-short combined value-momentum portfolio that outperforms value, growth, and momentum strategies, individually, as well as a combined growth-momentum approach, on average. Our white paper that shows this phenomenon can be downloaded here. 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. Exxon Mobil posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment, un-attractive relative valuation versus peers, and bearish techinicals. We use ConcoPhillips (COP), BP (BP), PetroChina (PTR), and Chevron (CVX) for our peer group analysis. For ConocoPhillips, we use the pre-spin-off entity.
Our Report on Exxon Mobil
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Exxon Mobil's 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 12.8% during the past three years.
The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $63, we'd take a closer look.
Exxon Mobil's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 4.2% during the past three years, lower than the mid-single-digit range we'd
expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.
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 2.3%. We expect the firm to pay out about 22% of next year's earnings to shareholders as dividends. We prefer other firms in the energy sector 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 (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Exxon Mobil's 3-year historical return on invested capital (without goodwill) is 12.8%, which is above the estimate of its cost of capital of 9.9%. 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
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. Exxon Mobil's free cash flow margin has averaged about 4.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. 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 Exxon Mobil, cash flow from operations increased about 95% from levels registered two years ago, while capital expenditures expanded about 38% over the same time period.
Our fair value for Exxon is $80 per share, which represents a price-to-earnings (P/E) ratio of about 9.5 times last year's earnings and an implied EV/EBITDA multiple of about 5.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 0.6%. Our model reflects a 5-year projected average operating margin of 11.9%, which is above Exxon Mobil's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3% for the next 15 years and 3% in perpetuity. For Exxon Mobil, we use a 9.9% 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 $80 per share, 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 Exxon Mobil. We think the firm is attractive below $63 per share (the green line), but quite expensive above $97 per share (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 Exxon Mobil's fair value at this point in time to be about $80 per share. 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 Exxon Mobil's expected equity value per share 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 shares 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 $101 per share in Year 3 represents our existing fair value per share of $80 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.