In this project we were asked to analyze three companies in the oil and gas industry. Firstly, we studied the dividend history of each of the firms. Unlike many other industries, all of our firms paid dividends during the period 1989 to 1998. We came up with two methods of calculating the dividend growth rate. Firstly, using 1989 as the base year and relating all dividends back to this year and secondly, comparing the growth of dividends on a year-to-year basis (i.e. taking the dividend in1997, subtracting from it the dividend in 1996, and then dividing the difference by the dividend in 1996).

We think that both of these methods are equally valid because they show different trends and patterns. Looking first at the year-by-year dividend calculations, some general trends can be observed, such as that all three companies had a positive average growth in dividends for the period. Simply, dividends actually went up rather than down. Growth rates for all three companies indicated an increasing trend till the year 1997 when they experienced a decline. In order to study the required rate of return for each companies stock, we used a geometric average of holding period returns for the past ten years. CHEVRON CORP.

Regarding Investors Required Rate of Return ( IRR) we estimated that due to the upcoming merger of Exxon and Mobil, Chevron’s IRR will increase to 22% compared to 20% which is the average for the past ten years. We also created a second rate of return, which will come into affect seven years from now in 2006, when we expect the market to stabilize after the effects of the merger. This rate will be lower than that of the first because the risk caused by the merger should have subsided by this time, thus we estimated it at about 17% which is close to but less than that of Mobil’s at present.

Another aspect that contributed to this decision was that if the rate were any lower investors would rather invest in Mobil or other oil companies of similar caliber. As a percentage of Net Income Chevron is paying the highest dividends, and due to its weak position with respect to competition it is essential for Chevron to pay high dividends to attract investors.

Regarding a reasonable range of required rates of return Chevron cannot fall far below Mobil and must stay close to 17% and within an upper limit that is logical compared to competitors. We studied the value of Chevron’s stock based on different rates of return and dividend growth rate assumptions (refer to appendix).

We selected the dividend growth rates of 6.4% and 3.2 %. We started off with 6.4% because this was the average growth rate of the dividends over the last 10 years. This rate applied for the first 6 years of our model (1999-2005) since we felt that we would have to keep the dividends at a high level due to the merger between Mobil and Exxon, because otherwise investors would not hold Chevron stocks. We chose 3.2% as the rate after 6 years because we thought that after the immediate period following the merger, things in the market would have stabilized and the rate of dividend growth could decrease yet investors would continue to hold the stock.

Based on these assumptions, the value of the stock is $19.711, considerably lower than the current market price of $85.50. So the stock appears to be over-valued and hence we recommend that investors sell the stock. The stock will remain over-valued despite varying dividend growth rates and rates of return. We varied these figures based upon

RateReasonG1 = 8.23%Average of the last three years growth ratesG2 = 4.115%1/2 of the average growth rate for the last three years G1,G2 = 10%The highest ever paid out dividendR1 = 14%Last year’s holding period returnR2 = 13%R2 would decrease slightly after merger. Stabilization R1, R2 = 24.43Average of the last three year’s rate of return R2 = 11%1/2 of 22% (our first assumption)

The current stock price for Chevron is $85.50 on closing of November 5th. The return the market requires is 5.75% (based on the original dividend assumptions mentioned above), however the r1 has to remain constant, as fluctuations in this figure will result in the sale of ownership in Chevron.

By changing dividend assumptions to 8.23% and 4.115% we find that the required market rate of return increases to 6.40%. In order to analyze the affect of dividend growth rate on market price we set the market price at $85.50 and calculated growth rate in dividends. By changing g2 the growth rate would be 15.01% if all other assumptions were held constant. By changing g1 to 8.23% the growth rate would be lower (14.775%) because higher dividends are paid earlier and therefore in the future dividend growth rate would be lower in order to compensate. EXXON and MOBIL

Exxon showed the most dramatic decrease in dividend growth of all the three companies, displaying a 3.25% decrease in 1998. The overall decrease throughout the companies may be a reflection of the economic crisis Asia has faced in recent times, which has also caused significant repercussions throughout the worldwide marketplace. Despite OPEC’s efforts to curb the worldwide extraction of oil, a number of companies defaulted on the agreement and thereby created excess supply and this resulted in low oil prices in the past year.

Low profits pushed dividends to lower levels, contributing in turn to low dividend growth. Exxon displayed an extremely low average in this respect compared to very similar rates of return for Chevron and Mobil at 20% and 18% respectively.

This was perhaps the result of stock splits causing closing prices to fluctuate greatly. In turn, sparse negative holding period returns occurred. This could be why the overall average resulted in such a low figure. Analyzing Exxon we estimated that before the upcoming merger the IRR would be 4.05%. The dividend growth rate for the past year declined sharply due to the circumstances discussed above, hence we considered this an irregular event.

Due to this assumption we selected 4.05% as a good estimate for 1999 based on the figures of 1997 and 1996, especially since Exxon being the largest of the three companies by far, can afford to have a low IRR in comparison. Here, the geometric average method of calculating the rate does not seem to be an accurate assessment since negative holding period returns caused the result to be extremely small and unrealistic. Regarding Mobil, the geometric average of the holding period returns for the past ten years was used as the Required Rate of Return for Investors and resulted in 18.02%.

or the next two years we assumed that it would be fairly accurate to use this average as a prediction of the IRR for 1999. Even though this value is lower than that of Chevron (22%), Mobil’s sheer size will attract investors despite this difference. We have assumed that the Exxon Mobil merger will go through by the year 2000 therefore new Investors Rates of Return must be estimated for the new joint company. Based on the stock price for both Exxon and Mobil, we took 40% of Exxon IRR and 60% of Mobil IRR and combined it to get 11.91% as a new IRR for the new company we termed “MobXon”.

This rate will be the second IRR for both companies, which will take affect in the year 2001. Studying the value of Exxon’s stock based on different rates of return and dividend growth rate assumptions (refer to appendix), we chose the dividend growth rates of 4.05% and 5.56%. We started off with 4.05% because this was the average growth rate of the dividends over the 10-year period. This rate applied for the first 2 years of our model (1999-2000).

The second dividend growth rate of 5.56% was derived from the same method as the second IRR using a breakup of 40% to 60% for Exxon and Mobil respectively. For Mobil we chose the dividend growth rate of 6.72% based on Mobil’s 10-year average of dividend growth. Again this number was used only for the first two years of our model. After the merger a second growth rate of 5.56% was applied to the model. This number was derived from the same method used above for Exxon.

This rate must be the same for both companies since they are now joined as one. Based on the assumptions that the first IRR is 4.05% (1999-2000), the second IRR is 11.91% (2000 onward), the first dividend growth rate is 4.05% (1999-2000) and the second dividend growth rate is 5.56% (2000 onward), the value of Exxon’s stock is $32.0178 and considerably lower than the current market price of $70.6250. So, as with Chevron, the stock appears to be over-valued and hence the recommendation is to sell the stock. At varying dividend growth rates and rates of return, we came to the conclusion that the stock would mostly remain over-valued. We varied these figures based upon RateReason

G2 = 8.1%Double of G1 (4.05%)G2 = 4.05%G2 remains the same as G1G2 = 6.72%The Growth rate of Mobil – Mobil is performing better in the stock market R2 = 18.02%IRR for Mobil – Investors in MobXon will not settle for less R2 = 20.00%Greater than 18.02% by some at least

R2 = 9.01%Double of R1R2 = 6.00% Due to Exxon’s size, Exxon R1 may have greater influence on MobXon RR thus pulling it down

The current stock price for Exxon is $70.625 on closing of November 5th. The return the market requires is 8.19% (based on the original dividend assumptions mentioned above), however we maintained a constant r1 because the period under study was too short (1999-2000) to allow any major fluctuations from the previous years.

We created an additional scenario that r1, r2 and g1 were constant at their original assumptions at 4.05%, 11.91% and 4.05% respectively. g2 was then altered to reflect the current stock price. The resulting rate was 9.231%. This number shows what the market expects the dividend growth rate of MobXon to be. In the third scenario we assumed r1, r2, and g2 constant at their original assumptions.

This resulted in g1 being 55.9230%. In this scenario we decided to alter g1 in order to see what the market thinks the growth is at currently. In the case of Mobil, based on the assumptions that the first IRR is 18.02% (1999-2000), the second IRR is 11.91% (from 2000 onward), the first dividend growth rate is 6.72% (1999-2000), the second dividend growth rate is 5.56% (from 2000 onward), and a 1.5 Merger Stock Ratio (for every share of Mobil, you receive 1.5 shares of MobXon), the value of Mobil’s stock is $42.3446 which is considerably lower than the current market price of $91.375. So, similar to Exxon and Chevron, the stock appears to be over-valued and hence we recommend that investors sell the stock.

At varying dividend growth rates and rates of return, the conclusion is the same as for Exxon and Chevron. We varied these figures using the same rates as Exxon due to the fact that they will merge and become the same company. Hence, their figures (r2 and g2) need to coincide (refer to table for Exxon and appendix). In addition, we performed two sets of computation: one with the Merger Stock Ratio of 1.5 and another with the ratio of 2. This was done in order to gain a broader perspective on the future value of MobXon since we do not know for sure what the terms of their merger is. However, the two values of 1.5 and 2 seem to the most reasonable.

The ratio of 1.5 was derived by looking at the current stock prices of Exxon and Mobil, which proportionally showed that for every share of Exxon you would receive one share of MobXon while one share of Mobil will be equal to 1.5 shares of MobXon. The second ratio of 2 was also considered a possibility considering that the Mobil’s stock performance as well as dividend growth figures are superior to that of Exxon’s.

The current stock price for Mobil is $91.375 on closing of November 5th. The return the market requires is 8.44% (based on the original dividend assumptions mentioned above and a merger stock ratio of 1.5). r1 and g1 remained constant in all of our scenarios because we truly feel that they are relatively close to the true figures. Under the same assumptions however altering the Merger Stock Ratio to 2, we found that the return the market requires changed to 9.38%.

This means that the market expects more return than the original assumption of the ratio being 1.5. We created two additional scenarios where g2 was the changing figure. All assumptions (r1, r2, and g1) remained at the original assumption values. The first scenario used a ratio of 1.5, which resulted in a g2 of 8.989%. The second, using a ratio of 2, resulted in a g2 figure of 8.043%. These figures represent what the market expects the dividend growth rate of MobXon to be in the future. CONCLUSION

Surprisingly, we found the stock prices of all three companies to be over-valued. This means that investors are paying too much for these stocks. Obviously, our opinions do not represent those of investors. The oil industry is one that holds many opportunities for growth and golden financial prospects. When investors look at an oil company they do not focus on its value based on rates of return, dividends, and growth. What they see is an industry producing an inelastic good that has endless demand and is one of the most basic necessities. In conclusion, any analysis done on the oil industry will fall short in determining the true value of these companies.