Why Royal Dutch Shell plc should be worth £40 per share

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Shell

Shell(LSE: RDSB) has enjoyed a relatively prosperous recent period. Since the start of 2016, its shares have risen in price by around 42% as the outlook for the Oil & Gas industry has improved. However, there could be a long way to go until the company appears to be fully valued. In fact, a share price of £40 would not be excessive. This means there could be the potential for an almost 100% capital gain over the medium term.

Dividend strength

At the present time, Shell is one of the highest-yielding shares in the FTSE 100. While the wider index currently yields around 3.7%, it has a dividend yield of around 6.5%. Part of the reason for it having such a high yield compared to its index peers is the fact that it decided to maintain a relatively high dividend even during a challenging period for the wider sector.

While many of its industry peers cut dividends significantly in order to maintain their financial strength, Shell's improving cash flow and modestly leveraged balance sheet meant it could afford to continue to pay a high proportion of earnings to shareholders in the form of a dividend without risking its financial future. Although this meant nearly all of its profit was paid out as a dividend, the company's income appeal remained high.

Capital gain prospects

While the price of oil could move either way later this year, Shell's dividend appears to be well-protected by its rising profitability. The company's strategy to reduce costs and cut capital expenditure could mean its earnings improve in the coming years, which may allow it to afford an even higher dividend. Given the prospects for rising inflation in the UK thanks to Brexit, and across the world as a result of Donald Trump's spending plans, higher yields could become more in-demand among investors.

In fact, if Shell traded on the same yield as the FTSE 100 of 3.7%, its shares would be trading above £40 at the present time. Given its upbeat outlook regarding profitability, dividend growth could be significantly higher than that of the wider index. As such, an even higher share price could be warranted over the medium term, meaning exceptionally high capital gains are on the cards.

Valuation

As well as its income appeal, Shell is also forecast to deliver high profit growth over the next two years. It is expected to record a rise in earnings of 27% next year, which puts its shares on a forward price-to-earnings (P/E) ratio of just 12.2. Alongside its future earnings growth potential, this valuation indicates that a doubling of its share price could take place, which would push it to beyond £40.

Certainly, Shell is not without risk. The oil price could easily fall in the near term. However, with a low valuation, high growth prospects and a dividend yield which few companies can match, a share price in excess of £40 appears to be easy to justify over the medium term.

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Peter Stephens owns shares of Royal Dutch Shell B. The Motley Fool UK has recommended Royal Dutch Shell B. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.