Even Under The Most Glorious Scenario BP Only Slightly Undervalued

July 15th, 2010 by hackel Leave a reply »

Surprise!  Investors get giddy, and we are seeing it with BP.

In fact, BP’s 7.5% rise today questions investor logic, absent a takeover bid, (less than 3% chance), or the price of crude jumping over $ 90/bbl.

This is because under the most optimistic of logical scenarios, one in which is as follows:

(1)  BP generates in excess of $3 billion in free cash flow this year and over $6 billion next (events which are extremely unlikely), and

(2)  its free cash flows exceed its past three-year average (pre-Gulf tragedy) starting in 2014,

(3)  its free cash flows rise by 45% over its past three-year average by 2016, and

(4)  we attach no more risk to this cash flow scenario than exists for the median S&P Industrial firm, meaning the increase in risk  associated with the past 2 months disappears.

These four assumptions, if realized, result in a current fair value of $43.25. A more realistic fair price is $40.37, which also takes off the table any additional negative event impacting the best-case cash flow forecast.

However, given another nasty surprise, the cost of equity capital (risk) is almost certain to jump over 11% .  I say an investment in BP is not worth  the risk for a minor return, especially as far greater opportunities, with considerably less risk exists elsewhere, both inside the sector and outside of it.

A 10% fall in the price of energy, even given a market cost of capital, takes the stock down at least 15%.  Of course, there is always the possibility that rumor and innuendo could take the stock higher, but I’m not one to invest in the greater fool theory, although that seems to work more often than I care to think.  Remember residential real estate?

See related articles:

Kenneth S. Hackel, C.F.A.
President
CT Capital LLC

www.credittrends.com

For additional information on this type analysis, pre-order- “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.

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