Undervalued Dividend Growth Stock of the Week: Exxon Mobil (XOM)

FOMO: fear of missing out.

It’s been with us for a while now, driving the market higher.

With the market now on shaky ground, pundits are now bringing attention to a new acronym.

FOSI: fear of staying in.

But as Warren Buffett has advised, it’s precisely when others become fearful that you want to become greedy.

Indeed, many stocks are much cheaper today than they were only weeks ago.

And that’s a great thing for those actively accumulating stocks for the long run.

It’s especially great for dividend growth investing practitioners.

This is an investment strategy that advocates buying and holding shares in world-class businesses that pay reliable, rising dividends.

These are some of the best stocks in the world.

That’s because they represent equity in some of the best businesses in the world.

The Dividend Champions, Contenders, and Challengers list is an invaluable resource containing data on hundreds of dividend growth stocks.

I’ve been using this strategy for more than a decade now.

It’s so powerful, it helped me to retire in my early 30s.

I lay out in my Early Retirement Blueprint exactly how I did that.

I now control the FIRE Fund.

That’s my real-money dividend growth stock portfolio, which produces enough five-figure passive dividend income to live off of.

As powerful as the dividend growth investing strategy is, valuation at the time of investment will have a lot to say about your results.

It’s price that you pay. But it’s value that you get.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk. 

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

While other fickle market participants shift from FOMO to FOSI, dividend growth investors taking advantage of lower valuations have an opportunity to supercharge their long-term investment results.

As complex as the subject of valuation might seem, it’s really not.

Fellow contributor Dave Van Knapp has made the subject a lot more approachable, via Lesson 11: Valuation.

Part of a more comprehensive series of “lessons” on dividend growth investing, it provides a valuation template that can be applied to nearly any dividend growth stock.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Exxon Mobil Corp. (XOM)

Exxon Mobil Corp. (XOM) is a multinational oil and gas company.

Founded in 1870, Exxon Mobil is now a $258 billion (by market cap) energy giant that employs 72,000 people.

Exxon Mobil is fully integrated across its three business segments: Upstream, Downstream, and Chemical.

With roots dating back to John D. Rockefeller’s formation of the Standard Oil Company more than 150 years ago, Exxon Mobil has proven out a rare kind of staying power.

But in all of its years of existence, the company might not have ever faced the kind of challenges it’s facing today.

The world is starting to transition away from hydrocarbons, instead favoring renewable sources of energy that can more cleanly and sustainably power the global society of tomorrow.

The market’s brutal punishing of this stock over the last 10 years is evidence of the challenges they face – this is a rare stock that’s actually down over the last decade.

However, every cloud has a silver lining.

And this cloud might have a particularly luminous silver lining.

I say that for two reasons.

First, the world still needs the type of traditional energy products that Exxon Mobil adeptly produces.

Perhaps the world is using renewable energy almost exclusively 50 years from now. Perhaps not. In the meantime, hydrocarbons currently account for more than 80% of the world’s energy consumption. Europe’s recent energy crisis shows what happens when governments try to pivot too quickly toward renewable energy sources that are not yet ready at the proper scale.

And that’s before even getting into the countless everyday products, like plastic, that require hydrocarbons for production.

Second, Exxon Mobil is reducing its annual capex budget from $30-$35 billion (pre-pandemic) to $20-$25 billion through 2027.

Because the world is trying to wean itself off of hydrocarbons, Exxon Mobil is scaling back on exploration projects. This reduces production output, which should help oil prices (as a result of lower supply).

Simultaneously, it frees up capital to be used toward debt repayment, buybacks, and increasing dividends.

It’s that latter aspect – increasing dividends – that is of special interest here.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Already, Exxon Mobil has increased its dividend for 39 consecutive years.

That easily qualifies them for their Dividend Aristocrat status.

The five-year dividend growth rate of 3.9% is nothing to write home about.

On the other hand, the stock offers a market-smashing yield of 5.7%.

That’s four times higher than the S&P 500’s yield.

It’s also 70 basis points higher than the stock’s own five-year average yield.

The payout ratio is admittedly a little hard to nail down right now, primarily because the last year has been so volatile for oil prices.

But their most recent earnings report – Q3 2021 – showed $1.58 in EPS, easily covering the $0.88 quarterly dividend.

And in that report, CEO Darren Woods pointed to the strength of free cash flow: “Free cash flow more than covered the dividend and $4 billion of additional debt reduction.”

The company also announced a $10 billion buyback program during Q3, in addition to paying down debt, so there are no issues whatsoever with covering the dividend.

Revenue and Earnings Growth

While these dividend metrics offer a lot to like, they’re looking backward.

Investors are risking today’s capital for tomorrow’s rewards.

As such, I’ll now build out a forward-looking growth trajectory for the business, which will later help when it comes time to value the stock.

I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.

I’ll then line that up against a near-term professional prognostication for profit growth.

Blending the proven past with a future forecast in this way should give us a lot to work with in terms of drawing conclusions about where the business might be going.

Exxon Mobil’s revenue is down sharply over the last decade, from $471.1 billion in FY 2011 to $178.6 billion in FY 2020.

Part of this decline looks more dramatic than it really is due to how much the pandemic affected the company from a complete collapse in oil prices.

To wit, oil pricing went negative for the first time ever in 2020.

Similarly, the growth picture for earnings per share is ugly – EPS moved downward from $8.42 in FY 2011 to -$5.25 in FY 2020.

I see some good news and some bad news here.

The bad news is that both revenue and profit are down meaningfully compared to a decade ago.

The good news is that both revenue and profit are down meaningfully compared to a decade ago.

I put it like this because this is a leaner, meaner Exxon Mobil than we’re used to seeing.

Less exploration and production puts a floor on oil prices via limited supply. At the same time, this frees up healthier cash flow to be used toward debt repayment, dividend increases, and buybacks – exactly what we saw play out in Q3.

Looking forward, CFRA currently has no forecast for Exxon Mobil’s EPS growth over the next three years.

It’s unusual for CFRA to have no forecast, but I understand the difficulty of trying to anticipate the company’s near-term growth path with so much uncertainty present.

What we can see is, Exxon Mobil has produced $3.33 in EPS for the first three quarters of 2021. Assuming a Q4 that’s similar to where Q3 came in at, FY 2021 EPS would be nearly $5.00.

That would be their best year since FY 2014.

Now, they’re not putting out the kind of gaudy numbers they used to put out. But the stock isn’t priced for that either.

Exxon Mobil was hovering around $100/share back in 2014. It’s now hovering around $60/share.

Even if we go back to FY 2017 and FY 2018, when Exxon Mobil was producing over $4.50 in EPS, the stock was routinely around $80/share.

Now, Exxon Mobil itself has announced that it plans to “double earnings and cash flow by 2027 versus 2019”.

Since they produced $3.36 in EPS for FY 2019, that puts their target at nearly $7.00 in EPS for 2027. This would be a marked acceleration in growth compared to what we’ve seen lately.

I think it’s prudent to expect low-single-digit annual EPS growth from here, based on a more focused business operating in a more favorable (but still very uncertain) environment.

And that would translate to like dividend growth, which is layered on top of a very appealing yield.

Financial Position

Moving over to the balance sheet, the financial position is great.

The long-term debt/equity ratio is 0.3, while the interest coverage ratio is currently N/A.

During better years, Exxon Mobil sported an interest coverage ratio that was very high.

I think their balance sheet is a source of strength, but the recent debt reduction is a welcome development.

Profitability is good, although more recent numbers artificially skew the averages negatively.

Over the last five years, the firm has averaged annual net margin of 3.1% and annual return on equity of 4.6%.

A more focused company should generate much better profitability.

There are two forces here that make Exxon Mobil more appealing than it’s been in a long time.

First, low expectations have pushed the stock’s price to levels that were normal 15 years ago.

Second, the more disciplined stance coming at a time when there’s a more favorable supply/demand dynamic bodes well for cash flow and shareholder returns.

And the company does benefit from durable competitive advantages that include global economies of scale, high barriers to entry, built-up reserves, established geopolitical relationships, and technological know-how.

Of course, there are risks to consider.

Litigation, regulation, and competition are omnipresent risks in every industry.

Regulation is arguably the biggest risk of these. Regulation has become more challenging as global governments try to transition away from hydrocarbons.

In light of the regulatory challenges and changes in energy, the very business model is a risk when looking out over decades.

There’s geopolitical risk here.

The company’s low-carbon investments, like carbon capture, are questionable in regard to reputational benefit, regulatory benefit, and overall ROI.

There’s a risk that long-term developments and their reserves could be stranded as the world transitions away from hydrocarbons.

The company is highly exposed to economic cycles.

Any lingering economic scars from the pandemic, resulting in less long-term demand for oil, would hurt the company.

And a faster-than-expected transition toward renewable energy is a big risk.

While these risks are considerable, I still believe Exxon Mobil can make for an acceptable long-term investment.

That’s especially true with the compressed valuation on a stock that’s priced similarly to where it was in 2005…

Stock Price Valuation

If Exxon Mobil can produce close to $5.00 in EPS for this fiscal year, that puts the forward P/E ratio at around 12.5.

That would be a very undemanding earnings multiple in this market.

We can also look at cash flow.

The P/CF ratio, at 7.5, is significantly lower than its five-year average of 10.9 – with 10.9 not being very high in and of itself.

And the yield, as noted earlier, is substantially higher than its own recent historical average.

So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?

I valued shares using a dividend discount model analysis.

I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 3%.

This is not far off from the company’s demonstrated five-year dividend growth rate. I’m basically extrapolating that out over the long term, albeit at a slightly more conservative rate than what’s recently transpired.

As I already pointed out, I think it’s prudent to expect low-single-digit EPS growth from the company over the foreseeable future. The company itself is guiding for something quite a bit higher than that through 2027, but oil prices are very volatile.

I see Exxon Mobil as less of a growth vehicle and more of a capital return vehicle at this point. The days of unbridled spending on exploration are gone, in my view. A more disciplined supermajor can be a great cash cow, even as the world’s reliance on traditional energy products slowly wanes.

Reduced spending putting a floor on oil prices, along with the redirection of cash flow toward buybacks, should be able to easily propel low-single-digit EPS and dividend growth.

The DDM analysis gives me a fair value of $72.51.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

I feel that I was fair, if cautious, with my valuation, yet the stock looks rather cheap.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates XOM as a 4-star stock, with a fair value estimate of $76.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates XOM as a 4-star “BUY”, with a 12-month target price of $74.00.

I came out slightly low, but the consensus is fairly tight here. Averaging the three numbers out gives us a final valuation of $74.17, which would indicate the stock is possibly 19% undervalued.

Bottom line: Exxon Mobil Corp. (XOM) is arguably more investable than it’s been in years. A leaner, meaner supermajor with more focus looks like a cash cow, yet the stock is priced like it was 15 years ago. With nearly 40 consecutive years of dividend increases, a market-smashing 5.7% yield, a possible near-term growth acceleration, and the potential that shares are 19% undervalued, this is a worthy long-term idea for income-oriented dividend growth investors.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

Note from DTA: How safe is XOM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, XOM’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.