Are Royal Dutch Shell plc shares overvalued?

Shell’s B shares are up 37% year-to-date – should you buy or sell?

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Royal Dutch Shell‘s (LSE: RDSB) ‘B’ shares have gained 37.1% year-to-date, as the London-listed energy giant benefited from this year’s oil price recovery and the fall in the value of sterling against the US dollar, the currency oil is priced in.

However, the rally is showing signs of running out of steam. The price of Brent crude oil has fallen back from a peak of $53 a barrel in October as investors await for specific details of OPEC’s proposed supply cut, and the pound has stabilised in the wake of better-than-expected UK economic data.

Overvalued?

The price-to-earnings ratio (P/E) – perhaps, the most popular valuation ratio used by investors – now stands at 42.9 times for the energy giant. So, are Shell shares overvalued?

That ratio compares very unfavourably to Shell’s historical 5-year average P/E of 13.6. However, the backward-looking ratio does not taking into account of its anticipated earnings recovery and so does not provide a useful picture of its future performance.

But, even on forward-looking valuation measures, the stock still trades at historically very high multiples. Its forward P/E ratios, which values the stock on its expected future earnings, is 31.6 times for 2016 and 17.3 for 2017.

Bulls vs bears

Does a forward P/E of more than 30 times scream overpriced or not?

It all depends on your outlook of Shell’s long term earnings potential. Bulls would say Shell’s acquisition of BG Group has made it a powerhouse in liquefied natural gas (LNG), controlling some 20% of the global trade in seaborne gas. It also has a bulked up presence in deepwater oil production and petrochemicals, which further differentiates it from its rivals.

Energy prices have stabilised, and Shell’s focus on capital spending, operating costs and synergies have helped its bottom line to recover from recent lows. The company could once again prove its mettle when energy prices recover.

On the other hand, a bearish investor could argue that Shell’s exposure to high-cost production means the company isn’t well placed to cope with the ‘lower for longer’ price outlook.

At best, low energy prices will pressure short term profits. However, there may be long term consequences too, if prices resume their downward trajectory – already, Shell’s reserves replacement ratio fell to -20% last year. This meant that Shell didn’t just failed to replace its production with new reserves, but reserves shrank beyond that because additional reserves were written off as they became uneconomic to produce in today’s price environment.

My take

With valuation multiples so high, I think it’s Shell’s 7.3% dividend yield that is supporting its shares. And because most analysts believe Shell is unlikely to abandon its dividend policy any time soon, valuations will likely remain high for some time.

That said, Shell’s dividends are not risk-free. The company’s dividend futures are currently pricing in a dividend cut of 14% for 2017. That’s not to say a 14% dividend reduction is set to take place next year, but that the market is valuing Shell’s future dividends at a 14% discount to its current quarterly payout of $0.47 per share.

Although the dividend may still be very tempting, Shell’s earnings multiples are extremely high relative to historic norms. A clear indication that profitability will recover to pre-crash levels may justify this, but I just can’t see that happening any time soon.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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