Editor's Choice

Oil Majors Look Cheap

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The oil majors have had a great year due to high refining margins, but the market is not giving them credit for it because refining margins are not expected to hold up. As a result, the companies trade at a low multiple of EBITDA and earnings.

<img src="/media/images/user_13490/ioc-comps_large.png" />

Though margin compression may drive down profitability in the short term, the companies look really cheap based on their long-term record of profitability. If you take the average pre-tax return on tangible invested assets (that is, pre-tax earnings as a percentage of tangible assets minus cash and current liabilities) for each company over the last ten years and apply it to each company's current level of tangible invested assets, you end up with the following trading multiples:

<img src="/media/images/user_13490/ico-normal-trading-comps_large.png" />

None of these companies trades for more than 4.5x 'normal' pre-tax earnings, assuming their average past performance represents their average future performance. So, it appears that the market has overreacted to a short-term problem, which presents an interesting opportunity in the shares of these companies.

For instance, Chevron (NYSE: CVX) trades at 3.6x EV/EBITDA and 4.4x normal pre-tax earnings. Chevron made a significant bet on several LNG projects which have positioned it for stellar growth in the years ahead. Meanwhile, the company's announced reduction in capital expenditures will result in higher free cash flow. All told, Chevron looks like an attractive buy.

In addition, ExxonMobil (NYSE: XOM) trades at just 4.1x normal pre-tax earnings despite a dominant global footprint and a long history of shareholder-friendly capital allocation. The company routinely earns one of the highest returns on invested capital in the industry. Management has also bought back a significant amount of stock while paying a competitive dividend over the last several years. As the dominant integrated oil company, Exxon is cheap enough to warrant a closer look.

Royal Dutch Shell (NYSE: RDS-A) has invested significantly in oil sands and other projects which are driving the company's free cash flow higher. Like Chevron, Shell is a major player in LNG with a strong presence in Asia. Shell is in prime position to take advantage of advances in technology that make previously-uneconomical projects profitable.

Finally, ConocoPhillips (NYSE: COP) looks like the cheapest of them all. At 2.9x EV/EBITDA and 3.9x normal pre-tax earnings, it is hard to pass over this company. In addition to the Warren Buffett seal of approval, ConocoPhillips is in a great position to take advantage of a rebound in natural gas prices. Investors who buy Conoco and hold for the long run will likely be rewarded with market-beating returns.

Final Thoughts

If investing were as simple as looking at a company's past record and determining whether the company was cheap or not, then there would be no cheap companies. Investors must be disciplined in the companies that they buy, choosing only those whose futures will almost certainly look like their past.

However, the starting point to finding good investments is to find companies that are trading at a discount to the value implied by their past record, a trait which applies to each of the companies mentioned in this article. It is up to each individual investor to determine whether or not their future will look like their past.

titans8904 owns shares of ExxonMobil. The Motley Fool recommends Chevron. The Motley Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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