If you don't know why BP's
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.
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|
|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.
Royal Dutch Shell
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|
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.