Valuation II. Earnings Declines

So now we have a baseline zero growth PE range, let's consider an example of a low PE -> XOM, with a current PE of about 11x, well under the baseline range. Further analysis is indicated.

What cash flow time series has a PE below the zero growth baseline? Answer: a declining / amortizing earnings stream. Example: Using 5.5% as a good quality corporate discount rate and a 20 year fully amortizing cash flow (i. e., the earnings are level and will disappear after 20 years, like a fully-amortizing mortgage), the annual payment is 8.37% which is a "PE" of 11.9x. Hmmm, pretty close.

So now you have what's necessary to evaluate XOM based on your outlook for its ability to find more oil & gas and for oil prices. The "efficient" market seems to be pricing XOM as if it will (a) disappear in about 20 years, (b) that it cannot replace its reserves, and (c) that oil & gas prices will not rise sufficiently to increase profits and ration demand much longer.

So if you have a different opinion of that, you know what to do. Buy XOM on any dip for a long term hold. They in fact ARE doing well in replacing reserves and have profitable refining & retail marketing businesses & have huge gas reserves, too. They have refining operations in China jointly with Aramco and have pieces of deep water oil off Angola. Management seems to care about shareholders & not waste money in poor investments or overpriced acquisitions.

You conclude correctly if you think that XOM is a substantial holding in my Alpha Fund.