FTSE 100 oil and gas giant Shell (LSE: SHEL) has seen its shares edge lower in recent weeks. I think much of this was down to profit-taking after its Q3 results released on 30 October rather than anything more fundamental.
That said, it does mark a rare dip from the sustained bullish run in the stock seen since April. So, this could be a chance for me to add to my holding in the shares.
To me this all depends on how the price-to-valuation gap looks in the stock.
So, how wide is it now?
Looking under the bonnet
Price is simply whatever the market will pay at any point in time. But value reflects the true worth of the underlying business, based on its fundamental operational strength.
Legendary investor Warren Buffett summed it up nicely, saying: “Price is what you pay; value is what you get.” He added that investors should focus on buying companies with a value that is greater than their price.
In my experience as well, it has been in this gap between a firm’s share price and its true worth that big long-term profits are made. The basic reason for this is that asset prices gravitate to their ‘fair value’ over time, whether up or down.
In Shell’s case, a discounted cash flow valuation shows it is a whopping 53% undervalued at its current £27.74 price.
So, its fair value is £59.02.
Do business fundamentals justify this?
In broad terms, Shell’s latest (Q3) results published on 30 October showed strong earnings, high cash flow, and further share-supportive measures.
More specifically, adjusted earnings of $5.4bn (£4.12bn) far outstripped analysts’ consensus forecasts of $5.09bn. This is crucial, as it is earnings growth that ultimately drives the share price and dividends of any firm higher over time.
A risk here is any environmental accident that could be costly to remedy and could damage Shell’s reputation.
That said, cash flow is another major driver of business expansion, and Shell saw this hit $12.2bn in Q3.
These big numbers reflected major production gains over the period. Its deepwater oil projects in Brazil, for example, saw their highest-ever quarterly output. And its oil and gas production in the Gulf of Mexico reached its highest quarterly level since 2005.
Its Marketing division also delivered its second-highest quarterly adjusted earnings in over 10 years.
My investment view
Aside from these strong fundamental factors in the business, Shell continues to lay the technical groundwork for share price gains.
Specifically, the Q3 results saw the announcement of another $3.5bn share buyback. This will be its 16th consecutive quarter of buybacks above $3bn.
It also rewarded shareholders with a 4.1% increase in the Q3 dividend from 34.4 cents to 35.8 cents. Its current dividend yield is 3.9% but analysts forecast this will rise to 4.1% next year and to 4.3% in 2027. By comparison, the current FTSE 100 average dividend yield is just 3.1%.
Given its huge undervaluation and rising dividend yield, powered by strong earnings growth prospects, I will be adding to my holding very soon.
I also have my eye on other highly undervalued stocks.
