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Geoff Gannon Investor Questions Podcast #19: What is Exxon Worth?

July 06, 2010 | About:
Geoff Gannon

Geoff Gannon

414 followers
Let’s check Exxon Mobil’s vital signs. Exxon Mobil (XOM) has a Z-Score of 19.26. The F-Score is 5. Free cash flow margin variation is 0.33. And the 10-year real free cash flow yield is 9.56%. Those are all solid numbers. Exxon is clearly a healthy stock.

Now let’s check Microsoft’s vital signs and compare them. Microsoft (MSFT) has a Z-Score of 22.01 versus 19.26 for Exxon. Microsoft’s F-Score is 5. That’s the same as Exxon. Microsoft’s free cash flow margin variation is 0.21 versus 0.33 for Exxon. And Microsoft’s 10-year average real free cash flow yield is 7.78%.

If you haven’t been listening to every episode, some of those numbers may sound like gibberish. The basic idea is that I check the same 4 numbers whenever I talk about any stock. It’s like checking a patient’s vital signs. But instead of checking things like blood pressure and pulse we check the Z-Score, F-Score, free cash flow margin variation, and real free cash flow yield.

http://www.investorquestionspodcast.com/storage/investor-questions-podcast-episodes/IQP_0019_What_Is_Exxon_Worth.mp3

It works the same way. This quick check helps us find problems quickly. It gives us warning signs. In this case, there are no warning signs for either stock. Both Exxon and Microsoft are financially strong companies. And neither stock looks expensive.

They both have lower than normal free cash flow margin variation. You’d expect that with Microsoft which sells two products, Windows and Office, that are pretty close to being subscription services for office workers. The company upgrades both products. And people buy new copies when they buy new computers. So even though Windows and Office aren’t literally disposable consumer goods, Microsoft looks a lot like a consumer products business. That’s especially true in terms of variation. There isn’t much variation at Microsoft. In fact, a closer look at the business shows that a lot of the variation comes from Microsoft’s other businesses. Windows and Office are even more stable than that 0.21 variation coefficient suggests. That’s for all of Microsoft. Windows and Office are the stable parts of the business. But Microsoft has gone into less stable and less profitable businesses in the last 10 years. Those skew the number.

Exxon’s free cash flow margin varies a lot more than Microsoft’s. But a variation coefficient of 0.33 is still incredibly low. Only stable businesses have such little variation. Exxon doesn’t look like a commodity business. Commodity businesses usually have a lot more variation in their free cash flow margins.

Enough with the vital signs. Let’s calculate Exxon’s intrinsic value. How much is this stock really worth?

The caller said he got an intrinsic value estimate of $153 a share for Exxon when he used the method I described in Investor Questions Podcast #1: How do You Determine the Intrinsic Value of a Company?.

I’m sure he did the calculation right. But I’m also sure the $153 a share estimate is way off. The estimate is wrong, because the method I used on Microsoft doesn’t work as well with Exxon.

When oil prices are high, Exxon has unusually high free cash flow. Also, in both cases, low interest rates push up the intrinsic value estimate. Low interest rates mean high free cash flow multiples.

I’ve thought about this problem a lot since the first podcast. I’ve decided it was wrong for me to say you should use today’s interest rates to get the free cash flow multiplier.

In theory, it’s a good idea. But I don’t like what it does in practice. Interest rates can be low when stock prices are high. That’s not unusual. Now, if you use really long-term averages for your earning power estimates that’s not so bad. But, if you use short-term averages, you could have a huge problem.

That’s what happened here. The caller did as I said in the first episode. And that’s fine if you have a stable business. But a cyclical business like oil can throw estimates off. That’s especially true, because I didn’t insist on using a long-term average in the first episode. Since then I’ve talked a lot about 10-year averages. But I didn’t stress that point in the first episode.

So, no, I don’t like the $153 a share estimate for Exxon. I’m worried that the multiplier is too high and the short-term free cash flow number is too high.

So let’s fix those 2 problems. Instead of using today’s interest rates, let’s use the Shiller P/E ratio. Or at least something a lot like it. The Shiller P/E ratio was created by the economist Robert Shiller. He wrote a book called “Irrational Exuberance”. The book showed how the U.S. stock market was too expensive in the late 1990s. Shiller did the same thing with housing a few years later.

The Shiller P/E ratio is just a 10-year average. It divides the price of the stock market by the average inflation adjusted earnings over the last 10 years.

I like the Shiller P/E ratio. It’s simple. And it works. I’ve used similar numbers in the past. And at least when you look at the overall market, the Shiller P/E ratio works well over the long-run. It gives you good predictions about the kind of returns investors will see over the next 10 or 15 years.

So that’s what we’ll use here. Since the 1880s, the average Shiller P/E has been around 16. At least that’s what you hear most people say. I think most people are using the arithmetic mean instead of the geometric mean. I’m not sure why they’re doing that. But I prefer the geometric mean. It’s just another kind of average. And it’s a bit lower. I also adjust for inflation differently. Those 2 changes bring the stock market’s “normal” 10-year average real P/E ratio down to 14.88. That’s equal to an earnings yield of 6.72%. To see that for yourself, divide 1 by 14.88. You get 6.72%.

So right off the bat we notice that the 10-year real free cash flow yield for both Exxon and Microsoft is higher than that 6.72% average. That suggests both stocks are cheap. And I agree with that. Microsoft and Exxon are both cheaper than you’d expect. A lot of big stocks are cheap right now. The overall market isn’t cheap. But huge, high-quality names like Exxon and Microsoft are cheap.

Of the 2 stocks, Exxon looks cheaper because it has a 10-year real free cash flow yield of 9.56%. Anything over 10% really gets my attention. You don’t normally see stocks like Exxon go over 10%. But Exxon is awfully close to that magic number as we speak.

Let’s not rush ahead. Instead of talking about whether or not you should buy Exxon stock, let’s just do the intrinsic value estimate. This is a quick method we’re using. It’s not perfect. But it is simple. And it does a decent job of telling you when a stock is super cheap or super expensive.

First: we figure out Exxon’s 10-year average real free cash flow per share. Obviously, we want the free cash flow per share based on today’s share count. So don’t go back and take the free cash flow per share from the past. Instead get the whole company’s free cash flow and then only turn it into a per share number at the end.

I won’t make you do the work. I’ll just tell you the number is $5.41 a share.

To turn that 10-year average real free cash flow per share into an intrinsic value estimate, we just multiply $5.41 a share by 14.88. That’s the same as dividing by 6.72%. Either way the answer is $80.50 a share.

Is Exxon really worth $80 share?

I don’t know. But it sounds about right. That’s actually not the most important number though. We want to know how you’ll do if you invest in Exxon.

So let’s assume you buy and hold the stock for 10 years. Now what does paying less than $57 a share for a stock that’s worth $80 do for your 10-year returns. Let’s assume it takes the full 10 years for the stock price to adjust. It never does. Stock prices bounce around a lot more than the companies themselves. Exxon’s stock price goes up and down more than it should. That means Exxon will probably get to $80 a share a lot faster than I’m suggesting here.

But we can’t count on that. We’re talking about investing, not trading. Let’s assume it takes the full 10 years. That would add 3.5% a year over the next 10 years.

Again, that 3.5% a year increase is just what’s needed to get Exxon’s stock back up to an appropriate price. What about the dividend? That adds another 3%. So we’re up to 6.5% a year just from the valuation adjustment and the dividend.

It sounds like I’m saying long-term investors in Exxon will get 6.5% a year even if Exxon doesn’t grow.

And that’s exactly what I am saying. Exxon is cheap enough to give you 6.5% a year even without growth.

For a lot of stocks, that would mean great returns. For Exxon it just means good returns. The company isn’t growing very fast. Over the last 10 years, sales have gone up just 3% a year. It’s usually a good idea to assume a business will grow slower in the future than it has in the past. So, I would never look at a business that grew 3% a year over the last 10 years and assume anything more than growth of 3% a year over the next 10 years. You should probably assume less.

That leaves Exxon investors with an expected total return of around 6 to 10% a year for the next 10 years.

I like that estimate. It’s simple. But my guess is that it’ about right. You can crunch a lot of numbers. You can do a deep analysis of Exxon and the oil industry. You can do a lot of things. But for investors rather than traders the answer is going to be about the same. Expect returns of 6% to 10% a year depending on future growth.

I like talking about Exxon in terms of future returns instead of focusing on intrinsic value, because it’s a slow-growth business. Intrinsic value is a great thing to know. But it can be misleading.

When you buy a cheap, slow-growing business, you need to lower your expectations. If it takes a long time for the market to see the value that’s already there, you’ll end up with modest returns. That’s not because you’re wrong. It’s just because you aren’t buying a fast growing business.

Buying stocks at a discount means your returns depend a lot on how fast you can flip those stocks. My guess is that you’ll be able to flip Exxon for a total return of more than just 6 to 10% a year sometime in the next few years. But don’t count on that. Instead, focus on the returns Exxon will give investors who hold it for the long-run. If the long-run means 10 years, I think a range of 6% to 10% is about right.

That might be better than the overall stock market. But it might not. I’d say stock market returns over the next 10 years will lean much more to the low side of that range. And because Exxon likes to give a lot of cash back to investors in dividends and buybacks, I think Exxon has a better shot at the top of the 6 to 10% a year range.

So, no, Exxon’s intrinsic value isn’t $150 a share. It’s more like $80 a share. And, if Exxon grows as slowly over the next 10 years as it did over the last 10 years, it could take you a while to see that $80.

But Exxon is definitely not an expensive stock. Investors who buy Exxon and hold it for 10 years can expect 6 to 10% a year. Most of that comes from Exxon’s dividend and its cheapness. The rest will come from growth. But I wouldn’t count on the growth. Only count on the first 6% a year, which is pretty much guaranteed.

Using the same method on Microsoft would give us an intrinsic value of $27 a share. Back in Investor Questions Podcast #1, I used a different method and said a range of $20 to $50 a share was right. The middle of that range, $35 a share was probably the most accurate number. But not necessarily the most conservative number. This method gives Microsoft a lower intrinsic value. Mostly because interest rates are low right now. If you put interest rates aside, $27 a share makes more sense than $35 a share.

Which method is right? The best idea is to use the method I showed you today. You shouldn’t count on today’s low interest rates. Yes. Interest rates are your opportunity cost. Yes. They are the yardstick you measure stocks against. But you can make that measurement yourself. You don’t need to actually put interest rates directly into the intrinsic value formula.

I like this way of calculating intrinsic value than the one I showed you in the first podcast. I haven’t learned anything new about stocks since I started doing the show. But I have learned more about investors. It’s been great to hear questions from listeners. But it’s also helped me see how cautious I have to be when talking about how much stocks are worth. From now on, I definitely want to err on the side of caution. I definitely want you to use the Shiller P/E multiplier instead of the interest rate multiplier. And I definitely want you to use a 10-year average instead of a 3-year average.

Those are just good common sense precautions. From now on, I’ll always use them whenever I talk about a stock. That means you won’t hear me saying Exxon is worth $150 a share. But $80 a share is possible. It all depends on future growth. I think it’s going to be low. But I could be wrong. If I’m wrong, double-digit returns are possible. If I’m right, a range of 6% to 10% makes the most sense.

Now what about Microsoft? What if we used this new intrinsic value method on that stock. Like I said, the intrinsic value estimate for Microsoft comes out at $27 a share. That means a 1.5% a year increase in the stock price to adjust the valuation over 10 years from the current price of $23 to the appropriate price of $27. Investors also get a 2.2% dividend yield. Put those numbers together and you get 3.7% a year before growth.

Microsoft has grown sales a lot faster than Exxon. Over the last 10 years, Microsoft’s sales have grown around 10% a year. I expect much slower growth over the next 10 years.

Also, there’s the issue of free cash flow stagnation. Microsoft’s margins have been getting worse over the last 10 years. So sales have grown faster than free cash flow.

But even if we’re just talking about 5% a year growth, Microsoft could still give investors returns of close to 9% a year over the next 10 years.

Microsoft’s range is a lot wider than Exxon’s. That’s because Microsoft can grow more than Exxon. But that means predicting the future. I don’t like doing that. I’d rather think of Microsoft as offering around 4% a year without growth and anywhere from 7% to 12% a year with growth.

So maybe there’s a little more upside in Microsoft than there is in Exxon.

Maybe. But none of this considers the balance sheets of the 2 companies. Both can buy back a lot of stock if they want to. They don’t have much debt compared to what they can safely carry.

The fact that both companies buy back their stock and pay dividends means you should take a hard look at the 10-year average real free cash flow yields. Once again, they are 9.56% for Exxon and 7.78% for Microsoft.

Those numbers look a lot like predictions for future returns. In fact, since both companies are so big, stable, and slow growing – I’m going to say those yields are probably as good a guess as any.

Yes. I’m saying all our hard work isn’t much better than just taking the average free cash flow for the last 10 years, adjusting it for inflation, and dividing by today’s stock price. An estimate of 8% returns for Microsoft and 10% returns for Exxon is as likely to be right as anything we come up with.

But that’s because these are predictable companies that give their free cash flow back to investors. If either of those things wasn’t true, the free cash flow yields would be important numbers, but they wouldn’t predict future returns.

But when you see a predictable business that pays out cash in buybacks and dividends, you can just take the free cash flow yield as your expected return.

Unless you expect growth. That’s a bonus.

But I don’t expect much growth for Exxon or Microsoft. So, unless they find dumb ways to spend their cash, investors should expect to see returns equal to the free cash flow yields. That means 7% to 10% a year for Exxon and Microsoft.

I know it sounds too simple to be true. And it might be. You still want to analyze the businesses. You still want to look at competition. But if you think the future will be a lot like the past, then free cash flow yields are as good a guide to future returns as anything we can come up with.

I like to keep things simple. So I’m going with the free cash flow yields and predicting 7% to 10% a year for Microsoft and Exxon.

That’s all for today’s show. If you have an investing question you want answered call 1-800-604-1929 and leave me a voice mail. That’s 1-800-604-1929.

Thanks for listening.



About the author:

Geoff Gannon
Geoff Gannon


Rating: 3.7/5 (12 votes)

Comments

apolloportfolio.com
Apolloportfolio.com premium member - 4 years ago
Hi, Geoff,

I am very happy to read your analysis and reasoning. Actually, I hold the same point of view as you. I really hope that both of us are right. Thanks for putting all of this thinking into reasonable and understandable format.

Regards,

Gordon Tam

Apolloportfolio.com Co-founder

bmichaud758
Bmichaud758 - 4 years ago
Geoff,

XOM earned roughly $40 billion pretax over the LTM in an oil price environment one could comfortably project for the next 10 years (I would even argue that once the global economy picks up in a couple of years that energy prices of all types will be significantly higher). If one assumes a $40 billion pretax perpetuity divided by post-XTO merger share count of 5,140 billion shares (not including XTO pretax earnings), per share pretax earnings are $7.78. At a share price of $58, that is a pretax yield of 13.4% with a free call on higher energy prices.

XOM is the Berkshire Hathaway of big oil - it is the premier operator in a capital-intensive industry, consistently earns above-industry average returns on invested capital, and rewards shareholders in a big way. I believe a long-term inflationary environment (deflation is definitely a concern over the medium term) combined with ferocious emerging market demand, energy will perform well. If energy performs well, the current 13.4% yield becomes 17%+ for XOM.

Under an "energy-performing-well" scenario, XOM earns $50 billion+ or $9.73 per share. If the 30y treasury reverts to a 6% level (3% real return + 3% inflation) and you add a 3% premium for required growth on XOM's part (the general real economic growth you would expect from a large corporation), the pretax multiple becomes 11X. At 11X $9.73, the per share intrinsic value becomes $107. If XOM earns $60 billion, the IVPS is $128.

I believe these are conservative estimates given long-term population growth (leading to increased energy demand), inflationary threats, emerging markets demand, and the superiority of XOM as an operator.

Disclosure: long XOM in a big way

bRain
BRain - 4 years ago
This stock also has a good short term catalyst. The short interest has been at 2% for the last few months, more than double the highest it has been in the last 5 years, even during the 2008 crash. For a stock with 4.7 billion shares outstanding this is huge, 94 million shares sold short. Investors may be shorting big oil to hedge against fears of the US offshore ban or concern that the XTO acquisition will take a longer timeframe to payoff because of persistent low natural gas prices. Eventually, the shorts will have to cover and you will see a good bump in price.

Long XOM
pvsk77
Pvsk77 - 4 years ago
One major point missed by the author is assuming a static dividend yield for XOM. This is a stock that has increased dividend consistently over past years
augustabound
Augustabound - 4 years ago


One major point missed by the author is assuming a static dividend yield for XOM. This is a stock that has increased dividend consistently over past years


I think that's more conservative than assuming regular dividend increases, even though they're likely.
pvsk77
Pvsk77 - 4 years ago
When I valued JNJ using the above mentioned methodology the value came out to 56.42.All the talks and articles in value investing forums about JNJ being so undervalued makes no sense. Either this method is too conservative are we are all duped into thinking JNJ is undervalued.

This reminds me of the misconception point brought by the author couple of episodes ago.

"Some thing may be undervalued because we say a temporary problem and the stock price is down"

However the reverse is not true. Just because we saw a price correction does not mean the stock is undervalued.

Great lesson.

P.S: It is so easy to use GuruFocus data on Free Cash Flow, is there a reason we should be using EDGAR, that seems so cumbersome
halis
Halis - 4 years ago
Disclosure: Long XOM

What a good article. I am not familiar with this podcast, but I enjoyed reading it. Anyway, I had a question. If you are assuming 3.5% capital gain in the share price and 3% from the dividend, why not add in share buybacks?

Shares outstanding have decreased for 10 consecutive years (and perhaps longer, I'm not sure) at a rate of about -3.75% per year. Since you are holding the stock long-term in this example, the value from the buyback would be captured. It doesn't seem unreasonable to me, to add in the buyback as well.

I hope my thinking isn't wrong here. If you add the dividend, the buyback seems to make sense as well.

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