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BP (LSE: BP) shares are down 10% from their 12 February one-year traded high of £4.71. The price movement has broadly followed that of the benchmark Brent oil price. This means that nothing of added value that BP does is reflected in the market assessment. This includes high-margin refined products, petrochemicals manufacturing, and various trading operations.
It underlines once again the disparity between a stock’s price and its value. The former is simply whatever the market will pay for any share at any given time. However, the latter reflects the full scope of a firm’s underlying business and the earnings growth it may see.
And it is ultimately this earnings growth that powers any firm’s share price and dividends higher over time. By using the latter, a fair value for any firm’s share can be pinpointed.
Earnings growth prospects
A risk to BP’s earnings is any environmental fallout from its drilling operations. This could be very costly to remedy and would damage its reputation. Such events have occurred before to it and other energy firms. Another risk is further tax rises by the UK government, which directly eat into profits.
That said, consensus analysts’ forecasts are that BP’s earnings will grow by 28.3% each year to the end of 2027.
Much of this is expected to result from BP’s re-energisation of its core oil and gas exploration and development activities. This followed its 26 February strategic reset to concentrate more on oil and gas and less on renewables spending. The stated aim is to grow cash flow and shareholder value.
To this end, the firm has announced several huge new oil and gas projects. On 6 August, it was awarded a $109m (£80.7m) contract to explore opportunities in Egypt. It has around 3.3bn barrels of proven crude oil reserves and about 78trn cubic feet of gas. This makes it one of the key oil and gas producers in Africa and the Eastern Mediterranean region.
On 4 August, it announced its largest oil and gas discovery in 25 years – ‘Bumerangue’ in Brazil’s Santos basin. No specific reserves figure has been given by BP, but it said it is probably its biggest find since ‘Shah Deniz’ in 1999. This Caspian Sea site had 1trn cubic metres of gas and 2bn barrels of condensate initially in place.
The firm is also moving ahead with enormous field developments in the Gulf of Mexico and Iraq. Its fields in the former contain around 10bn barrels of oil and in the latter around 9bn barrels.
The share’s fair value and dividend yield
I have found discounted cash flow analysis to be the best way to ascertain a share’s fair value. This clearly identifies where any firm’s stock price should trade, based on cash flow forecasts for the underlying business.
In BP’s case, the shares are 52% undervalued at their current £4.23 price.
Therefore, their fair value is £8.81.
I think its strong earnings growth will power the stock towards this level over time.
I also think it will drive its dividend yield higher too. Indeed, the consensus analysts’ forecast is that this will rise from the present 5.8% to 6.1% next year and 6.3% in 2027.
Given these factors, I will buy more of the stock very soon.
