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By: Ahmed Ishtiaq

ConocoPhillips (COP) is the world's biggest production and exploration company based on oil production and reserves. The firm searches for gas and oil in more than 30 countries and has reserves of 8.4 billion barrels of oil equivalent. COP produced approximately 1.6 million barrels per day in 2011. In 2012 ConocoPhillips spun off its refining and marketing unit as Phillips 66. Prior to the spinoff, the company had a refining capacity of more than 2.2 million barrels per day. The firm also had 8,300 retail outlets in the US under the 76, Conoco, and Phillips 66 brands, and at 1,700 owned or dealer-owned gas stations in Europe.

As of the time of writing this article, COP stock was trading at around $57.72, with a 52-week range of $56.62 - $78.24. It has a market cap of about $70.1 billion. The trailing twelve-month P/E ratio of 7.1 is below the forward P/E ratio of 9.0. P/B, P/S, and P/CF ratios stand at 1.5, 0.3, and 4.6, respectively. The operating margin is 9.1% while the net profit margin is 4.2%. The company has a low debt load, with a debt/equity ratio of 0.4.

ConocoPhillips has a 2-star rating from Morningstar. Out of ten analysts covering the stock, four have a buy recommendation and two have sell recommendations. On the other hand, most of the analysts have market outperform rating, and four analysts have recently upgraded the stock. Average five-year annualized growth forecast estimate is 1.32%.

We can estimate ConocoPhillips fair value using discounted earnings plus equity model as follows.

Discounted Earnings plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year. The average EPS for ConocoPhillips is $4.50.

While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 1.32%. Book value per share is $39.42.

V0

E0

$4.50

V1

E0 (1+g)/(1+r)

$4.11

V2

E0((1+g)/(1+r))2

$3.75

V3

E0((1+g)/(1+r))3

$3.42

V4

E0((1+g)/(1+r))4

$3.12

V5

E0((1+g)/(1+r))5

$2.85

D

E0(1+g)5/[r(1+r)5]

$25.92

BV

Equals

$39.42

Fair Value Range

Lower Boundary

$47.68

Upper Boundary

$87.10

Potential

50.90%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for ConocoPhillips is between $47.68 and $87.10 per share. At a price of about $57.72, ConocoPhillips is trading close to the lower boundary of its fair value range. The stock still has up to 51% upside potential to reach its fair value maximum.

Summary

Energy sector is showing signs of recovery due to improving economic conditions. At the moment, global economy is showing slow recovery. However, global economy will recover at a much faster pace over the next two years. I believe this is the best time to enter the energy sector. According to my valuation model, there is a lot of upside potential in ConocoPhillips. Furthermore, the stock is one of the best dividend payers out there. As a result, income investors are attracted towards this stock. ConocoPhillips provides the opportunity to collect dividends with substantial upside potential.

Source: ConocoPhillips Has Substantial Upside Potential