Following up on recent articles, it might be beneficial to work through real stock selection examples. My first example compares two of the largest worldwide integrated oil companies, Chevron (CVX) and Exxon (XOM), along with the largest Canadian company, Suncor (SU).
I will attempt to cut through much financial gobbledygook (it’s a real word in spell-check) to explain a simple process injecting a little humour into the dryness. Many retail investors pay no attention to financials and simply get recommendations and stories off popular websites like Reddit. This process will not work, at least without exceptional luck.
Some retail investors will look at price/earnings (P/E) and dividend yield to determine best value. P/E or any of the price ratios are simply how many dollars you must pay to get a dollar of earnings, or cash flow, etc. A P/E of 14.6 means you pay $14.60 to get a dollar of annual earnings, based on the latest financials. SU’s $14.60 per dollar of earnings is clearly better value than CVX’s $21.10 per dollar of earnings, or is it?
Read Also
Oval Office intrigue drags on farm-level decisions
A rational family sitting down for a budget discussion should raise savings, reduce the risk those savings face when invested, and make a point to keep up with every twist and turn of emerging U.S. tariff and tax policy.
A valuation metric (how much you pay) such as P/E or price/cash flow (P/CF) is useless on its own without also evaluating a company efficiency metric (how much the company makes) such as return on equity (ROE) or my favorite cash flow/assets (CF/A), a mistake I have made in the past.
P/E is by far the most watched valuation metric but there is a simpler and better way, with greater consistency of results. P/CF is a better metric than P/E according to a research report I read many years ago. Because cash flow is simpler and less manipulated than earnings, I always gravitated towards it. Simple is good!
Moving to cash flow we see that SU is again the best value. We only pay $5.10 per dollar of annual cash flow, which is half the price of CVX’s $11.30 per dollar of annual cash flow. Half-price sale, stock up (pun intended). What about company efficiency and growth?
SU’s CF/A of 14.0 is once again better than CVX’s, with SU producing 14.0 cents of cash flow from every dollar of assets employed, superior to CVX’s 12.1 cents per dollar. Growth is important as the market pays more for growing companies. Well look at that, SU has also been the fastest growing company. My growth ratios are a simple division of 2021 numbers over 2012, on a per share basis. Oil prices were robust in 2012, so the fact that revenue and cash flow was lower in 2021 is understandable. SU, however, had some growth … bonus!
I look at all the metrics mentioned from a watch-out perspective, but because there are only so many factors my little brain can consider when making decisions, I focus on the primary three for decision-making.
In this example, using the traditional P/E would lead to the same conclusion as the CF focus. In future examples that may not always be the case. My ranking of these stocks would be SU first, followed closely by XOM. In fact, I sold CVX purchased in 2006 at $57.85 and purchased XOM. Historically, their valuations have been similar making this divergence perplexing. I continue to hold SU and might add more in time. All oil stocks embed a fair bit of political risk.
On that matter, I would like to refer to past articles. In the April 20, 2021, issue I raised the question whether environmental, social and governance (ESG) investing was a fad and said it had morphed into simply an anti-oil movement. A recent Globe and Mail article (David Berman, March 21, 2022) shared that at year-end 2021, ESG mutual funds and exchange-traded funds held a total of $300 million in the four largest Canadian energy companies while holding $603 million in the four largest Russian companies. Canadian oilsands are more carbon intense than most sources, but these funds completely ignored the social and governance aspects.
How could anyone of sound mind believe after Crimea, after the 2014 invasion of Western Ukraine, after Syria, after …, that Russian oil was societally more wholesome than Canadian oil? Well, apparently ESG funds did!
My article, “A long road back,” appeared on January 18, 2022. It ended with, “It illustrates how sentiment can change.” It is so unfortunate it took an absolute crisis to wake people up but U.S. support for Keystone surged from under 50 per cent to more than 70 per cent recently, while Canadian support for development of our natural resources surged similarly. At least the people have awoken but will the politicians?
As an FYI, my recent article, “The Looming Energy Predicament,” was written before the invasion, although it appeared afterwards. The supply predicament has quickly deteriorated with the egregious behaviour of Putin. We have supported both humanitarian aid and helped purchase supplies for Ukraine’s civilian Territorial Defense Forces. For more information on this effort, please email [email protected] and #StandWithUkraine.
