This P/E Suggests Royal Dutch Shell plc (ADR) (RDS.B) Is a Buy

LONDON — The FTSE 100 has risen by 25% over the last year, and many top shares are beginning to look quite expensive.

I’m on the hunt for companies that still look cheap, based on their long-term earnings potential. To help me hunt down these bargains, I’m using a special version of the price to earnings ratio called the PE10, which is one of my favorite tools for value investing.

The PE10 compares the current share price with average earnings per share for the last 10 years. This smoothes out any short-term volatility and lets you see whether a company looks cheap compared to its long-term earnings.

Today, I’m going to take a look at the PE10 for the oil and gas supermajor Royal Dutch Shell plc (ADR) (NYSE:RDS.B).

Is Shell a buy?
Over the last year, Royal Dutch Shell plc (ADR) (NYSE:RDS.B)’s share price has risen by just 8.8%, leaving it well behind the FTSE 100, which has gained nearly 25%. However, as the largest company in the FTSE 100 — with a market capitalization of £279 billion — Royal Dutch Shell plc (ADR) (NYSE:RDS.B)’s main purpose is to generate a reliable dividend income for its shareholders, not capital growth.

Shell has a strong track record as an income share, and currently offers a dividend yield of 5.4%, with a five-year average dividend growth rate of 3.6%.

Let’s take a look at Shell’s current price-to-earnings ratio, and its PE10:

Royal Dutch Shell plc (ADR) (NYSE:RDS.B)’s current share price of around 2,245 pence is 9.6 times its average earnings over the last 10 years.

Although this is slightly more expensive than its current P/E of 8.4, I believe that Shell is still a strong buy for income investors.

Production growth = rising income
At the core of Royal Dutch Shell plc (ADR) (NYSE:RDS.B)’s business is the principle that long-term production growth should be used to generate financial growth — and ultimately a rising dividend.

This can go wrong if the oil price plummets, as happened in 2008/2009, but over the long term it has worked well, thanks to Shell’s size and its global mix of oil and gas assets. Shell’s current strategy is for production output to rise from 3.3 million barrels of oil equivalent in 2012 to 4.0 million barrels of oil equivalent in 2017/2018, an increase of 21%.

Given the rising global demand for gas and firm demand for oil, I believe that Royal Dutch Shell plc (ADR) (NYSE:RDS.B)’s forecasts are quite realistic and rate it a strong buy for future income.

The article This P/E Suggests Royal Dutch Shell Is a Buy originally appeared on Fool.com and is written by Roland Head.

Roland Head owns shares in Royal Dutch Shell. The Motley Fool has no position in any of the stocks mentioned.

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