Shares of Chevron (CVX 0.57%) hit an all-time high of nearly $190 a share earlier this year. While the oil giant has come off its peak, shares are up about 70% over the last three years and remain significantly above the average trading price over the past decade. That might have value investors thinking the stock isn't worth their time.
However, a closer look at a key valuation metric tells a different story: Chevron is a lot cheaper than it appears. That should make the oil stock appealing to bargain-hunting investors.
Drilling down into Chevron's valuation
Investors have many ways to value a stock. One of my favorite valuation methods is to look at a company's free cash flow yield. Free cash flow is the money a company generates that it can use to create value for investors by paying dividends, investing in growth (e.g., capital expenditures or acquisitions), repaying debt, or repurchasing shares. The higher the free cash flow yield, the less investors are paying for the free cash flow and the faster the investment payback period.
Here's a look at Chevron's free cash flow yield using data from independent research technology firm New Constructs.
Data source: New Constructs.
This graph shows that at recent prices, Chevron trades at an 8.8% free cash flow yield. That's the cheapest it has been over the past several years. It's also a bit cheaper than other energy stocks (New Constructs notes that the Energy Select SPDR ETF trades at an 8% free cash flow yield). Meanwhile, Chevron's stock is significantly cheaper than the broader market (New Constructs pegs the free cash flow yield of the S&P 500 at 3%).
That relatively high free cash flow yield is one of the many reasons Chevron has earned an Attractive rating from New Constructs, which recommends investors buy the oil stock.
Free cash flow catalysts on the horizon
One potential pitfall of using a free cash flow yield is that it's a backward-looking metric. While that doesn't matter if a company produces steady cash flow, it can prove problematic for companies with variable cash flows, like oil companies.
Chevron's free cash flow rises and falls with oil prices. With oil prices declining in recent months, Chevron's cash flow will likely fall in the near term.
However, the medium and longer-term outlook for Chevron's free cash flow is much brighter. For starters, oil prices appear poised to rally in the coming months. The International Energy Agency (IEA) noted in its May oil market report that demand is stronger than expected this year, fueled by China's post-pandemic recovery. Meanwhile, supply is growing tighter due to significant outages in key production regions, which will only worsen as OPEC+ cuts production. These dynamics led the IEA to forecast a gap of 2 million barrels per day between supply and demand developing over the second half of this year. A gap that wide will undoubtedly drive up oil prices.
While higher oil prices will certainly benefit Chevron, it doesn't need them to grow its free cash flow over the longer term. The company's strategy of investing in high-return, low-cost-of-supply projects has it on track to grow its free cash flow at a more than 10% compound annual rate through 2027. That forecast assumes an average oil price of around $60 a barrel, more than $10 below the recent price.
Using its free cash flow to grow shareholder value
Chevron's capital allocation strategy begins and ends with returning free cash flow to shareholders. The oil giant's No. 1 financial priority is to pay a growing dividend. That payout is currently well above average (its dividend yield is almost 4%, more than double that of the S&P 500) because the company trades at a low valuation (i.e., high free cash flow yield).
The oil giant has increased that payout for 36 straight years, including growing it at a 6% compound annual rate over the last 15 years (and double the rate of its closest peer over the past five years). That payout seems destined to continue growing, given the company's expectation of double-digit annual free cash flow growth at lower oil prices.
The final aspect of Chevron's capital allocation strategy is repurchasing shares. The oil company plans to buy back $10 billion to $20 billion of stock each year through 2027. Given its current low valuation, that's enough money to retire 3% to 6% of its outstanding shares each year. It stress-tested that plan and can achieve the low end of its share repurchase range even if oil averages $50 a barrel in the 2025 to 2027 timeframe.
Chevron is a bargain
Chevron currently trades at about an 8.8% free cash flow yield, which looks cheap compared to the broader market and Chevron's free cash flow growth catalysts. That higher yield is a big driver of Chevron's higher dividend yield. It also enables the company to repurchase a meaningful amount of shares. Add it all up, and the oil giant looks like an attractive buy for bargain-hunting investors these days.
