Is It Time to Buy Royal Dutch Shell's Stock?

If you are looking at investing in Royal Dutch Shell, then you have probably looked at all of the other integrated oil and gas companies as well. After all, the logic for buying Shell is very similar to the rest of the bunch. So, what is it that sets Royal Dutch Shell apart from the rest, and why should Shell be your choice? To help you make a decision on whether to buy Shell's stock, let's take a look at how it stands in comparison to its peers, as well as how the company's shares are valued in relation to both the market as well at Shell's historical valuation. 

Shell's case that it's the best of the bunch

Shell hasn't exactly been the best-performing company in terms of earnings or returns recently, and management isn't trying to hide it, either. In its most recent analyst presentation, Shell shows that it has been the worst performer on both earnings per share as well as return on average capital employed over the past four years. The only thing that has likely kept it from being one of the worst-performing Big Oil players over that time period was the Macondo well blowout, which decimated BP's share price. 

Source: Royal Dutch Shell Investor Presentation.

The one thing Shell does appear to have going for it, though, is cash flow generation. Not only has the company been able to remain the second best company in terms of cash flow growth over the past few years, but its recent moves to clear cash-consuming aspects of the business have improved its free cash flow significantly. So far this year, Shell has generated almost as much cash as it did in all of 2012, which was the best year for free cash flow since before the financial crisis.

Source: Royal Dutch Shell Earnings Presentation.

This big uptick in cash flow is a promising sign, especially since Shell and some of its peers have been struggling to convert operations to free cash in the past couple of years.

Source: Royal Dutch Shell Earnings Presentation.

If Shell can maintain this pace and see robust growth in free cash flow, it would give Shell's management a lot more flexibility in what it would like to do in the future -- with either the ability to throw off some extra cash to shareholders through buybacks, or even look to make a few well-placed acquisitions. This could go a long way toward improving Shell's stock performance.

Scouring through the numbers

One thing you need to keep in mind when looking at Shell and the other members of Big Oil is that it is a cyclical business heavily reliant on the price of oil to drive earnings. In fact, this cyclical nature is why the entire energy sector trades at a Robert Schiller adjusted price to earnings ratio of 16, while the Schiller adjusted P/E ratio of the S&P 500 is at 26.3. So, just because the valuation for these companies is considerably lower than the S&P doesn't mean they are cheap. That being said, let's take a look at the numbers for Shell and its peers.

Company Price/Earnings Enterprise Value/EBITDA Enterprise Value/Total Revenue Price/Tangible Book Value
Royal Dutch Shell 15.9x 5.3x 0.7x 1.5x
Chevron 12.2x 4.3x 1.2x 1.6x
ExxonMobil 12.6x 5.9x 1.1x 2.3x
BP 13.6x 4.8x 0.5x 1.5x
Total 12.1x 4.6x 0.8x 1.8x

Source: S&P Capital IQ.

Even though Shell is trading right around the broader sector average and is pretty close on EBITDA and sales ratios, it is trading at a bit of a premium to the rest when it comes to price to earnings. The reason it is close on EBITDA and revenue metrics but not on earnings has a lot to do with the fact that its margins are on the weak side compared to its peers.

Company Gross Margin EBITDA Margin Net Income Margin
Royal Dutch Shell 15.6% 10.9% 3.64%
Chevron 28.8% 19.4% 9.61%
ExxonMobil 28.3% 15.6% 8.59%
BP  12.3% 8.6% 3.04%
Total 29.2% 16.1% 5.45%

Source: S&P Capital IQ.

What really brings Shell's numbers into perspective is comparing them to historical averages. Compared to its historical valuation over the past 10 years, Shell looks pretty overvalued based on its current price to earnings ratio and its enterprise value to EBITDA ratio.

Royal Dutch Shell's Valuation Today Historical Average (last 10 years)
Price/Earnings 15.9x 8.75x
Enterprise Value/EBITDA 5.3x 4.24x
Enterprise Value/Total Revenue 0.62x 0.7x
Price/Tangible Book 1.5x


Source: S&P Capital IQ.

One thing to note, though, is that Shell's shares trade at a slight discount as far as price to tangible book and price to total revenue. This could indicate two things: 1) That there are some large items on Shell's books that aren't generating income -- cough, Kashagan, cough -- and once they do, it will increase earnings and in turn lower the earnings ratios; or 2) There are a high amount of overvalued assets on the books that generate lots of sales, but little profitability. Considering the company is in the middle of a major asset sale to increase cash flows, I would lean toward the latter.

What a Fool believes

Shell may be generating some pretty large sums of free cash today, but there aren't many other things that really wow investors with this company. It trades at a premium to its peers while generating lower returns on capital and pretty weak margins overall. There is a possibility investors are betting Shell will emerge as a more profitable company after its major asset sales and divestment program, but that is a little more speculative, because we don't exactly know what the company would look like afterwards.

If forced to make a decision on whether to buy now or not. I personally would decline and look at one of its peers, like ExxonMobil or Chevron, because their outlooks for future cash flow and earnings are clearer, and their capital spending programs aren't being cut as much. Also, these companies both trade at a slight discount to Shell and are closer to their historical average valuations today.

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