What's Behind Schlumberger's New $168 Price Target?

Over the last year, Schlumberger (NYSE: SLB  ) has jumped 65% and outperformed the S&P 500 by a staggering 44%. The past year has been exceptional for its shareholders, but will this performance continue?

Further to go
Morgan Stanley believes that Schlumberger can push higher. Around 43% higher in fact, and this news caused the company's shares to surge. But is this more Wall Street hopeium, or can Schlumberger really double from current levels?

To arrive at the price target of $168 per share, analysts at Morgan Stanley have used Schlumberger's own forecasts. Schlumberger believes that through 2017, assuming that the oil and gas industry's capital spending grows by around 6% per annum, earnings per share should expand 15% per annum. On this basis, Schlumberger expects to earn $9-$10 per share by 2017.

On a forward P/E basis, these predictions mean that Schlumberger is currently trading at a 2017 P/E of 13.1 to 11.8, which is not overly demanding.

However, Morgan Stanley's analysts go a step further by factoring in Schlumberger's free cash flow yield to arrive at their price target.

So what free cash flow yields do Schlumberger and its peers offer? Well, according to Morgan Stanley, peers Cameron International, Dril-Quip, and FMC Technologies trade at free cash flow yields of around 3%, while Halliburton (NYSE: HAL  ) has a free cash flow yield of just over 1%.

Schlumberger has a free cash flow yield of about 3.5%. These metrics make Schlumberger look cheap compared to its peers while Halliburton, on the other hand, appears expensive.

What about that $168 target?
You may be asking how Morgan Stanley's analysts came up with a price target of $168 per share. They used Schlumberger's own forecasts which, as mentioned above, call for 2017 EPS of $9-$10 during 2017. Historically, the company has converted 75% of its earnings per share into free cash flow, which implies that by 2017 the company will be producing cash flow of $6.75-$7.50 per share.

Analysts then discounted this figure back at 10% for two years. Assuming that the company continues to trade at a free cash flow yield of 3.5% in 2017 gives you a price target of $168. At the high end of $7.50 in earnings per share Schlumberger's shares could trade at $200, assuming a free cash flow multiple of 3.5%.

A likely scenario
Working through the analysis above, it does seem as if Morgan Stanley's analysts have a point about Schlumberger's price target. What's more, it would appear that the company's peer Halliburton could actually be overvalued.

Halliburton, like Schlumberger, has put in a solid performance over the past few years, and this is set to continue. As shale oil projects become ever more prevalent around the world, Halliburton's services and products will be in demand. Additionally, Halliburton has the highest return on capital in its peer group and profit margins are widening.

However, with such a high valuation on free cash flow compared to that of peer Schlumberger, it does seem as if Schlumberger is the better pick, on a valuation basis anyway.

What's more, Halliburton has more exposure to the North American market, which makes the company more cyclical than Schlumberger. Unfortunately, companies with cyclical natures do not deserve higher valuations than their peers (in this case Schlumberger) that operate within more stable operating environments.

Foolish summary
Overall, based on Schlumberger's own forecasts, there is no reason to doubt the fact that the company's shares could hit the $168 price target set by Morgan Stanley's analysts.

On the other hand, there is evidence to suggest that at current levels Schlumberger's peer Halliburton could be overvalued. Schlumberger is set for rapid growth over the next few years and its shareholders are set to see the value of their holdings soar.

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