Royal Dutch Shell (LON:RDSA, LON:RDSB) usually needs little introduction. It is one of the world’s largest oil and gas companies, originally formed in 1907 through the merger of Royal Dutch and Shell Transport and Trading, although the two companies only formally unified into a single holding company in 2005.
Shell is now the largest company on the London Stock Exchange with a market capitalisation of some £137bn taking into account its ‘A’ and ‘B’ classes of share capital. In 2012 it was also the largest dividend payer on the FTSE when excluding the special dividend of Vodafone so perhaps unsurprisingly then it is a core shareholding of many funds and income portfolios.
In Shell’s results for the year ended 31 December 2012 the company reported basic earnings per share (on a current cost of supplies basis) of $4.32 and a dividend for the year of $1.72. At a current share price for the class B shares (the ones usually purchased by UK investors for withholding tax reasons) of 2,178p and based upon current exchanges rates I make that a trailing P/E ratio of just 7.7 and a dividend yield of 5.2%.
In the context of the FTSE’s current P/E ratio of 14 and dividend yield of 3.5% this might initially look to be an enticing large cap value proposition and I have read a few opinions recently which suggest that Shell is very ‘cheap’. However, I am rather more cautious than that, principally because I think the accounting earnings overstate the true earnings of the company.
Shell’s ‘owner earnings’
In my last article discussing the concept of ‘quality’ I referred to Warren Buffett’s definition of ‘owner earnings’ which he considers to be more relevant for valuation purposes than accounting earnings. The reason for this is that it more closely reflects the amount of cash an owner of the business could take out each year after allowing for the cash needed to be spent in order to maintain the company’s operating capacity. Interestingly, in the same piece Buffett then when on to say this in the context of owner earnings usually being lower than accounting earnings:
The oil industry has in recent years provided a conspicuous example of this phenomenon. Had most major oil companies spent only [their depreciation, depletion and amortisation charge] each year, they would have…
