It’s been a year since my last value stock pick. I haven’t been buying stock and have been focused on building up a war chest I can use to buy stocks and other assets at a discount when the US economy faces it’s next crash.
I don’t know when the next stock market crash will take place nor have I failed to notice that stocks are up some 300% since the lows of the 2008 financial crisis.
So I maintain some exposure to stocks even though I believe the stock market a whole is overvalued.
I believe value stocks will continue to outperform in the long term.
I prefer value stocks that pay a dividend yield. My March 2018 pick is a cash flow machine.
March Value Stock Pick
Royal Dutch Shell (RDSb London Stock Exchange, RDS.B NYSE)
Remember here are the metrics I look at:
1) Enterprise Value to Market Capitalization (EV/Market Cap)
2) Enterprise Value to Free Cash Flow (EV/FCF)
3) Enterprise Value to Earnings Before Interest and Tax (EV/EBIT)
4) Enterprise Value to Owners’ Cash Profits (OCP)
5) Operating Margin
6) Dividend Yield
7) Return on Equity (ROE)
Energy production is very capital intensive so I’ve decided to compare Royal Dutch Shell (RDSb) to similar companies: Exxon Mobil (XOM), Total (TOT), and Chevron (CVX).
Data is from Morningstar as of 13 March 2018 (with the exception of EV/Owner’s Cash Profits) which is from yCharts as of 16 March 2018.
So how does RDS stack up?
1) EV/Market Cap
I like to see an EV/Market Cap below 1. Of these four energy companies none meets this criteria and RDSb is actually the highest. Total is the lowest just edging out Exxon Mobil by what amounts to a rounding error.
RDSb – 1.242
XOM – 1.134
TOT – 1.129
CVX – 1.154
Winner: Total (TOT)
2) Enterprise Value to Free Cash Flow (EV/FCF)
EV/FCF is where RDSb really shines compared to it’s peers. EV/FCF is in my view a more accurate measure than Price to Earnings (PE). The lower the number the better.
RDSb – 19.55
XOM – 24.42
TOT – 28.99
CVX – 36.15
Winner: Royal Dutch Shell (RDSb)
3) Enterprise Value to Earnings Before Interest and Tax (EV/EBIT)
Another metric where lower is better.
RDSb – 18.31
XOM – 18.57
TOT – 14.68
CVX – 26.98
Winner: Total (TOT)
4) Enterprise Value to Owners’ Cash Profits (OCP)
16 March 2018 Update:
EV to Owners’ Cash Profits is another metric that I believe is more accurate than price to earnings.
EV / Owner’s Cash Profits / EV/Owner’s Cash Profits
RDSb – 331.89 / 8.875 / 37.4
XOM – 357.85 / 9.753 / 36.69
TOT – 170.82 / 5.36 / 31.88
CVX – 254.97 / 0.758 / 336.41
Winner: Total (TOT)
Source: yCharts
5) Operating Margin %
All else equal a higher operating margin percent is better than a lower one. Exxon Mobil takes the cake in this metric.
RDSb – 6.59%
XOM – 19.71%
TOT – 4.91%
CVX – 6.72%
Winner: Exxon Mobil (XOM)
6) Dividend Yield
Stocks in the oil and gas industry typically pay good dividends. Shell pays the highest of these four:
RDSb – 5.86%
XOM – 4.09%
TOT – 4.84%
CVX – 3.73%
Winner: Royal Dutch Shell (RDSb)
7) Return on Equity (ROE)
The ROE of Shell lags it’s peers. I typically look for an ROE over 8%.
(TTM) / (5 Year)
RDSb – 5.61% / 6.48%
XOM – 11.10% / 13.54%
TOT – 7.85% / 8.19%
CVX – 6.26% / 8.31%
Winner: Exxon Mobil (XOM)
Reasons to be Cautious
Shell has a payout ratio of 144.6%. That means that the dividend might be unsustainable.
However, Shell’s payout ratio has been below 100% from 2008 up through 2014 and I think that the payout ratio will drop to a sustainable level in the next year or two.
The return on equity for shell has also been lower than I’d like but they are also in stronger financial shape (based on the current ratio and quick ratio) than ROE king Exxon.
Another Valuation Metric
One way to calculate a margin of safety is by determining what multiple of the EBIT the stock is trading at. I could write an entire article on how this is calculated (shout out to Jason Rivera who I learned this technique from).
Basically I’m looking at (EBIT * 14) + Cash Equivalent / Shares
Using the number 14 in the equation might seem somewhat arbitrary but it isn’t. The reason I chose that is because if you plug in 13.5 you get the current share price of Shell. In other words Shell is trading at EBIT x 13.5 + Cash Equivalents.
Using this metric (using a multiple of 14) we find a “fair” share price of each of these four stocks would be as follows:
RDSb – $65.9
XOM – $64.1
TOT – $75.8
CVX – $72.7
And if we compare the actual share price to these values we get the following “margin of safety” for each stock:
(EBIT * 14 + Cash) / (Current Share Price) / (Margin of Safety)
RDSb – $65.9 / $63.59 / -3.49%
XOM – $64.1 / $74.53 / 16.27%
TOT – $75.8 / $57.66 / -23.91%
CVX – $72.7 / $116.46 / 60.12%
Winner: Total (TOT)
Using this technique we can see that Shell is trading at about a 3.5% discount to 14xEBIT + Cash. Exxon is trading at a 16.27% premium, Total is trading at a generous 23.91% discount and Chevron is overvalued by a large 60.12%.
Even though it is in a totally different industry, just for fun, I decided to compare this to Netflix (NFLX). NFLX is currently trading at $315.88 per share. At 14 times EBIT plus cash NFLX should be trading at $6.32 and at current prices it is trading at a a 4,900% premium.
I would venture to say that Netflix is overvalued.
Class A or Class B?
I used to own RDSa in a Roth IRA. The RDSa shares are subject to a 15% withholding to the Dutch government. Because of this RDSa trades at a discount to RDSb, which does not have this withholding.
At one point you could get around the 15% withholding through Shell’s scrip program (which they have discounted twice) and get a lower price and higher yield.
But given that the scrip program has been discontinued I choose to own RDSb. I prefer to own it on the London Stock Exchange but I do own it in US markets in a Roth IRA.
Shell is a great value
Shell is a great value and a cash flow machine with a strong dividend. Total is an excellent value as well although it has thin operating margins and has struggled to generate free cash flow with the same consistency as Shell and so for those reasons I prefer Shell.