After a summer slump, oil prices are back at the yearly highs. Yet, stocks like Exxon Mobil Corporation (NYSE: XOM) slightly lag behind this positive development.
In this article, we'll try to gauge how much by looking at the discounted cash flow (DCF) analysis.
Although many have written off oil as an energy source of the past, this doesn't mean it will disappear overnight, and its price will fall off a cliff. On the contrary, the U.S. Energy Information Administration (EIA) recently released a short-term energy outlook, forecasting the average price of the West Texas Intermediate (WTI) at US$71 per barrel till the end of 2021 and US$66 per barrel in 2022. As cheap oil sources get exhausted, EIA sees the brent crude prices go to US$89/barrel by 2030 and US$185/barrel by 2050.
Yet, OPEC is expecting the energy demand to increase by 28% between 2020 and 2045. Although renewable energies will see the highest growth, all other sources are growing, except for coal. Although electric vehicles will experience growth, internal combustion vehicles will retain the lead during this time through fleet increases in developing regions.
Meanwhile, Bank of America expects Exxon Mobil to raise the dividend using the Q3 earnings – after meeting the net debt target lower than 25%. It keeps the buy rating and a US$90 price target.
The dividend, which remains one of the highest in the industry, is currently yielding 5.81%.
Assessing the Intrinsic Value
We generally believe that a company's value is the present value of all cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
We will use a two-stage DCF model, which, as the name states, considers two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second "steady growth" period. To begin with, we have to get estimates of the next ten years of cash flows. Where possible, we use analyst estimates, but when these aren't available, we extrapolate the previous free cash flow (FCF) from the last estimate or reported value.
We assume companies with shrinking free cash flow will slow their rate of shrinkage and that companies with growing free cash flow will see their growth rate slow over this period. We do this to reflect that growth tends to slow more early than in later years.
Generally, we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$22.4b||US$21.0b||US$20.8b||US$21.7b||US$21.7b||US$21.8b||US$22.0b||US$22.2b||US$22.5b||US$22.9b|
|Growth Rate Estimate Source||Analyst x11||Analyst x9||Analyst x2||Analyst x2||Est @ -0.18%||Est @ 0.46%||Est @ 0.91%||Est @ 1.23%||Est @ 1.45%||Est @ 1.6%|
|Present Value ($, Millions) Discounted @ 8.3%||US$20.7k||US$17.9k||US$16.4k||US$15.8k||US$14.6k||US$13.5k||US$12.6k||US$11.8k||US$11.0k||US$10.4k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$145b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage.
For a number of reasons, a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case, we have used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth.
In the same way, as with the 10-year "growth" period, we discount future cash flows to today's value, using a cost of equity of 8.3%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r - g) = US$23b× (1 + 2.0%) ÷ (8.3% - 2.0%) = US$370b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$370b÷ ( 1 + 8.3%)10= US$167b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$312b. In the final step, we divide the equity value by the number of shares outstanding.
Relative to the current share price of US$58.8, the company appears a touch undervalued at a 20% discount to where the stock price trades currently. Remember, though, that this is just an approximate valuation.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. The DCF also does not consider the possible cyclicality of an industry or its future capital requirements, so it does not give a complete picture of its potential performance.
Given that we are looking at Exxon Mobil as potential shareholders, the cost of equity is used as the discount rate rather than the cost of capital (or the weighted average cost of capital, WACC), which accounts for debt.
We've used 8.3% in this calculation, which is based on a levered beta of 1.439. Beta is a measure of a stock's volatility compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation.
Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result.
For Exxon Mobil, we've compiled three important items you should explore:
- Risks: Every company has them, and we've spotted 1 warning sign for Exxon Mobil you should know about.
- Future Earnings: How does XOM's growth rate compare to its peers and the broader market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High-Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock, search here.
Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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