Could BP's Stock Double?

If you don't know why BP's (NYSE: BP  ) stock has been roughly handled by the market, it's quite possible that you've been living under a rock.

Even after a significant recovery, BP's stock is still trading more than 20% lower than where it was prior to the Deepwater Horizon explosion and Gulf of Mexico oil spill. And even when it was at those higher, prespill levels, there were plenty of investors who thought the stock was undervalued.

So as we look at BP's stock today, could there be big returns up ahead? Let's take a closer look.

Earnings expectations
As I outlined in a previous article, a good way to get a baseline for growth expectations is to check on what Wall Street analysts expect and how fast the company has actually grown in the past.

Metric Annual Growth Rate
Analysts' estimates 12.4%
10-year historical 4.9%
5-year historical (1.3%)
3-year historical (0.4%)
Last 12 months 24.3%

Source: Capital IQ, a Standard & Poor's company. Historical growth based on operating earnings.

Now comes the tougher part: How fast do we actually believe BP can grow? For obvious reasons, the company is highly dependent on the price of oil, and while that's a big plus for BP and other oil players right now, the tensions in the Middle East could ease and send the price of oil tumbling. In addition, all major oil companies have to deal with the fact that new oil finds are becoming harder to come by, and to the extent that BP isn't able to replace its reserves -- well, that could also cramp growth.

With all of that in mind, I think that analysts' estimates are far too optimistic. I think that a relatively optimistic, but more realistic, view would be for BP's profits to grow 5% per year over the next five years. With that as the upper end of my range, I assumed for my base-case that BP's earnings will stay relatively flat with current earnings (adjusted for spill costs of course). My downside case is for earnings to decline by 3% per year.

To put that bottom-end case in context, for the five-year period ending in 2009, BP's operating income had declined by 0.7% per year and for the five years ending in 2002 operating earnings showed a similar annual decline. Spill impact excluded, those were the only two times over the past decade where earnings declined over a five-year period.

Pinning down valuation
Valuations are a moving target that can be tough to predict, but, as with growth above, using a range of values can give us a view of our potential returns without requiring a Miss Cleo-type prescience.

In creating our range, a good place to start is where the stock is trading right now and what its historical trading range has been. This is a bit tricky for BP since spill costs pushed its bottom line into the red for 2010. However, if we use adjusted earnings per share of $6.86, we can say that BP's stock is trading at 6.7 times trailing earnings. Looking back over the past 10 years though, the stock's average annual earnings multiple has been in a wide range between 10 and 30.

For broader context we can also look at how similar companies trade.

Company

Trailing P/E

Estimated Growth

ExxonMobil (NYSE: XOM  ) 13.6 6.0%
Royal Dutch Shell (NYSE: RDS-A  ) 10.9 19.3%
Chevron (NYSE: CVX  ) 11.4 2.4%
Total (NYSE: TOT  ) 9.2 11.8%
ConocoPhillips (NYSE: COP  ) 10.5 1.4%
Eni (NYSE: E  ) 10.2 9.9%

Source: Capital IQ, a Standard & Poor's company.

While these companies aren't all exactly the same as BP, the businesses are similar enough that we can definitely glean something from their valuations. Of course, the biggest difference between BP and the group above is that none of the  companies listed have the specter of one of the largest oil spills in history hanging over them. And that is a very significant fact because while I by no means want to minimize the spill, I believe the sentiment will continue to change over time and BP's valuation multiples will start to look more like the rest of the group.

So where does this leave us? Staying relatively conservative, on the upside I could see BP's stock trading at the higher end of the comparable company range -- so I set the upper end of my range at 13. My base case is for a multiple of 10, which is closer to the current middle of the pack, and my downside case has a multiple of nine.

Dividends and share count
Our final stop is to consider how much we'll get paid through dividends and whether changes in share count will impact our bottom line.

My main concern with share count is that I'll end up with a company that has a history of significant dilution. That's far from ideal because big share issuances cut the portion of the profits that each share receives. BP's share count did creep up between 2000 and 2001 and again, to a much lesser degree, between 2009 and 2010. However, the overall share count has declined by roughly 13% over the past 10 years, so there's not much to worry about here.

The company's dividend is an interesting question. After suspending payouts during the worst of the spill backlash, the company has started paying again, though at half of the prespill rate. The downside to this is that shareholders are getting a smaller current payout. However, the lower current dividend also means that BP can grow its dividend at a pretty robust rate even if earnings growth is lackluster -- which is exactly what we're assuming.

I've set my range for annual dividend growth with the high end at 12% -- slightly below the 14% 10-year rate -- the midpoint at 10%, and the low end at 8%.

The verdict please!
The end result of all of this is the returns we can expect under the various scenarios. Here's what my three scenarios would look like:

Scenario Annual Earnings per Share Growth Earnings Multiple Annual Dividend Growth Expected Annual Returns
Upside 5% 13 12% 23.5%
Midcase 0% 10 10% 12.5%
Downside (3%) 9 8% 7.3%

Source: Author's calculations.

Let's now go back to that question that we started with: Can BP's stock double? Under the upside scenario, the answer is a very definite "yes." The midcase wouldn't quite get us there, but it's still not too-shabby of a return. And as far as downside scenarios go, a 7.3% annual return is pretty attractive. Given that these are my views on BP's potential returns, it may not be too surprising that I am -- and plan to continue to be -- a BP shareholder.

Of course the future is an ever-changing picture, so you need to keep on top of what's going on at BP to see which set of numbers the company and stock are able to live up to. And you can do just that by adding BP to your Foolish watchlist.

Chevron and Total are Motley Fool Income Investor selections. The Fool owns shares of Exxon Mobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of BP, Total, and Chevron, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool’s disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (10) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 05, 2011, at 11:54 AM, cyberschreiber wrote:

    "For obvious reasons, the company is highly dependent on the price of oil, and while that's a big plus for BP and other oil players right now, the tensions in the Middle East could ease and send the price of oil tumbling."

    I always wonder about the correlation of the price of oil and the earnings of the big integrated oil multinationals... It is obviously not a 1:1 relation... Any insights here?

  • Report this Comment On April 05, 2011, at 12:24 PM, anonmouse wrote:

    "the tensions in the Middle East could ease and send the price of oil tumbling."

    Actually the reverse is true. The price of oil easing will help to stabilise the global economy and stop the Market's worry of a return to Recession and therefore the SP should rise on a falling oil price and conversely fall when it goes above $120 a barrel (and the Market then enters a period of uncertainty). In fact this is exactly what has been happening over the past months.

    As for a 23% upside - nonsense. It's going to be far more than that. 50%-100% easily. Of the $20 billion fund only $4 billion has been paid out. It's unlikely that any more will be. My estimation will be another $4 billion in fines, although this will be shared with TransOcean and the others. The finger pointing of the US administration will ultimately lead to their own lax auditing and rubber stamping of the Safety processes and with TNK paid off with the remains of the $20 billion fund the only way for this stock is up... way up!

  • Report this Comment On April 05, 2011, at 1:01 PM, TMFKopp wrote:

    @cyberschreiber

    "I always wonder about the correlation of the price of oil and the earnings of the big integrated oil multinationals... It is obviously not a 1:1 relation... Any insights here?"

    You're correct that it's not a simple 1:1 relationship. Nor is there any other easy ratio that we could use.

    If you wanted to figure out the exact impact, your best bet would be to model it out. That would get a bit complex since you'd not only be looking at the company's crude production capacity, but also hedges, refining capacity, what types of crude are produced, etc., but it'd probably be the most accurate route.

    Matt

  • Report this Comment On April 05, 2011, at 1:06 PM, TMFKopp wrote:

    @anonmouse

    "The price of oil easing will help to stabilise the global economy and stop the Market's worry of a return to Recession and therefore the SP should rise on a falling oil price and conversely fall when it goes above $120 a barrel"

    What's good for the S&P isn't necessarily good for BP or its stock. A more optimistic tone for the global outlook -- specifically via peace in the Middle East (had to do it) -- would provide an offset to the impact of lower oil prices, but if oil falls significantly when ME tensions ease, that's not good news for the oil majors' bottom lines.

    "As for a 23% upside - nonsense. It's going to be far more than that. 50%-100% easily."

    That top-end scenario calls for an average 23% stock appreciation *per year* over the next five years.

    Matt

  • Report this Comment On April 05, 2011, at 5:37 PM, fightingfinn wrote:

    BRAVO MATT!!

    This article represents what the Fool stands for. It is by far the best piece I have seen in a while. You took a commonly held stock, 2nd largest position in my personal portfolio, and took us on a journey through earnings projections that was both educational and practically useful. Even if your numbers turn out to be way off and the your conclusions prove inaccurate, this was still a valuable article because it showed the PROCESS you used to get to those projections and numbers. The edjamacashun was well worth the price of admittance.

    That said, your points were all well reasoned and have left me feeling better about my BP investment than before I read the article.

    Thank you for sharing that with us!

  • Report this Comment On April 06, 2011, at 8:04 AM, firemachine69 wrote:

    Final question is... Do we wait for quarterly DOW, or before?

    (Looking to go long...)

  • Report this Comment On April 06, 2011, at 1:55 PM, TMFKopp wrote:

    @fightingfinn

    Thanks and glad you enjoyed it!

    One of the keys to laying it out this way is that it also makes it very easy to track how the company is performing and where the investment outperformed (or fell short).

    A year or two from now, I can go back and look at those projections and compare them to the actual earnings and dividend growth and valuation multiple and reevaluate whether the company is performing on track.

    I would really encourage all investors to do some sort of exercise like this. As nice as the end result is, the process (as you highlight) is particularly important and helps you think through a lot of aspects of the investment.

    Matt

  • Report this Comment On April 06, 2011, at 1:57 PM, TMFKopp wrote:

    @firemachine69

    I'm not sure I follow your question...

    Matt

  • Report this Comment On April 07, 2011, at 1:37 PM, cyberschreiber wrote:

    @Matt

    I even believe that Peter Voser, CEO of Royal Dutch, made the case in a Swiss newspaper that price increases in oil are actually BAD for the company for two reasons: input costs for refinery etc. is higher and windfall taxes will increase...

    By the way: Spot on, Matt, I read all your articles. Although I do not invest in US equities (the dollar goes down the drain compared to my home currency, the Swiss franc, so I would have to hedge a lot...), I still learn a lot from you.

  • Report this Comment On April 08, 2011, at 11:57 PM, PeakOilBill wrote:

    Tensions in the Middle East could ease. Don't hold your breath. Sunnis (Saudi Arabia, Egypt) & Shites (Iran) have been fighting each other for centuries. And it looks like the Iranians are planning to try and encircle Saudi Arabia with friendly militant Shite regimes to me. Even if no religious war starts, many geologists are now saying that were are approaching peak oil production. Quite a few are now writing that we are in the 'plateau' phase of oil output, when production will stay nearly flat for a few more years, before beginning a decline of between 2 to 4% per year. I fall in this camp. If I'm still around in 2016, and oil output hasn't started to decline, I will be shocked. I feel that only a massive increase in exports by Iraq can prevent that now. Whatever the timing, as soon as it becomes obvious that global oil production has begun to decrease, the oil price will begin to continuously increase. Demand from China and India, along with the oil exporters wanting to save some FOR THEIR OWN CITIZENS, will see to that. I don't see how such a rapid price increase won't cause another Great Depression in a country so dependent on gasoline to get to work. As the cost of gasoline goes up and up, the demand destruction for everything else will be enormous.

    I hope I'm wrong. I just read an excellent book by Kenneth D. Worth entitled, 'Peak Oil and the Second Great Depression 2010-2030'. I HIGHLY recommend that all investors do likewise. It is short, cheap, and brilliant. I own no stock at this time. Good luck. I'm hoping to read how wrong I was in 2017. I might make 67.

    So BP could double. And the companies involved in doing the oil finding, drilling and servicing wells could go up even more.

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