Are Royal Dutch Shell plc shares overvalued?

Royal Dutch Shells (LSE: RDSB) B shares have gained 37.1% year-to-date, as the London-listed energy giant benefited from this years 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 OPECs 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 Shells 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 Shells long term earnings potential. Bulls would say Shells 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 Shells 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 Shells exposure to high-cost production means the company isnt 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, Shells reserves replacement ratio fell to -20% last year. This meant that Shell didnt 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 todays price environment.

My take

With valuation multiples so high, I think its Shells 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, Shells dividends are not risk-free. The companys dividend futures are currently pricing in a dividend cut of 14% for 2017. Thats not to say a 14% dividend reduction is set to take place next year, but that the market is valuing Shells future dividends at a 14% discount to its current quarterly payout of $0.47 per share.

Although the dividend may still be very tempting, Shells earningsmultiples are extremely high relative tohistoric norms. A clear indication that profitability will recover to pre-crash levels may justify this, but I just cant see that happening any time soon.