What Makes BP Compelling Over The Next 5 Years

| About: BP p.l.c. (BP)

Although there are a wide host of ingredients that come together to form a fair value stock price for a given company, there are two factors in particular that come together to determine what a company should be worth in a rational market: the future profits that a company will generate, and the quality of those profits.

When we look at the oil supermajors like Exxon (NYSE:XOM) and Chevron (NYSE:CVX), there is not a whole lot of room for those companies to improve earnings quality. Exxon already earns $38 billion annually across 48 different countries with its hands in almost every cookie jar. There is not a whole lot of room for Exxon to improve its earnings quality. The same story largely exists for Chevron as well, although the company might stand to gain a bump of 5-15% to reflect higher earnings quality once its lawsuit stemming from Texaco's alleged misdeeds years ago clear up.

What are the implications of that? If you are an Exxon or Chevron shareholder, your primary source of capital appreciation will be driven by earnings per share growth and dividends received, because it is unlikely that the quality of the profits will rise in a manner that would justify any kind of added premium over time. That is not a bad place to be (over the past twenty years, Exxon has returned 11.7% annually and Chevron has returned 12.4% annually while the S&P 500 has returned 8.5% annually), but the point is to understand the terms of the investment.

But BP (NYSE:BP) is a different animal. For investors looking to buy shares today in the $40-$43 range, there is a potential to benefit from two forces simultaneously: the improvement in earnings quality that will lead to a higher valuation multiple, and earnings per share growth (as well as dividends paid out) that will drive the future growth of this investment.

Let's consider the first element: earnings quality. Reviewing data from 1997 through the oil spill, there was only one year when the company's typical P/E ratio fell below 10x earnings. If you manually remove the years of rapid energy price changes from consideration and focus on BP's valuation during times of stable prices in the thirteen years before the spill, you will see that BP traded in an average range of 10.9x earnings to 12.8x earnings. And from a dividend perspective, there was no point between 1997 and 2007 in which the company's average dividend yield was above 3.70%.

BP has already sold off over $40 billion worth of assets, and even taking that into consideration, the company is still expected to pump out $5.50 in earnings per share this year. Warren Buffett has been known to say that "the investor of today does not profit from yesterday's growth." Well, there is a corollary to that. The investor of today is not harmed by the earnings impairment of a company's past. It is all about the relationship between current profits, future profits, the quality of those profits, and the price you can get your hands on a share of those profits.

Based on present known risk factors, the primary threat to BP shareholders looking to initiate a position today would be if (1) energy prices fell materially over the next three to five years and (2) BP is found culpable of gross negligence and has to sell off more assets than expected during a time of lower energy prices, weakening the long-term earnings power of the firm. Even under that "worst case scenario", investors might be able to do all right if the $0.54 quarterly dividend holds steady and the company ended up earning $4-$5 per share for a prolonged period of time. That would be a bit of a grind for the long-term shareholder, but there are a lot worse things in life than collecting a 5% dividend yield as a consolation for long-term patience.

But it is a technique out of Graham and Dodd Security Analysis playbook to find companies with low expectations and "fear" built into the stock price because these kinds of fears have a tendency to be overblown, and even reasonable performance can lead to great returns because the expectations in the current stock price are so low.

The other way that BP shareholders can benefit over the next five years is in the form of earnings per share growth. Even adjusting for the $40 billion asset sell off, analyst estimates peg BP's five-year earnings per share at $7.50. From my point of view, the whole point of owning an excellent company is the fact it can withstand a lot of abuse and still reward shareholders. Even with the recent asset selloff, BP is still a monster generating 2.4 million barrels of oil and oil equivalents per day, and the company is sitting on almost 5 billion barrels of oil in its proven reserves, and over 33 trillion cubic feet of natural gas. That leads me to conclude that BP is here to stay, even in a worst case scenario.

That is what makes BP appealing: it stands to benefit from both improved earnings quality (once the lawsuit uncertainty overhang is removed) and long-term earnings growth. If the company meets the analyst estimates of $7.50 per share five years from now, and trades at the low end of its historical range of 10x earnings, you are looking at a $75 per share company, plus a 5% dividend that has gotten in the habit of growing again. Either way, you can increase your paper wealth if: (1) profits stay static and the P/E ratio approaches historical norms of 10-12x earnings, or (2) profits continue to increase and the P/E ratio stays at its depressed levels. At current prices, not a whole lot has to go right for a BP investment to achieve reasonable returns over the medium term.

Disclosure: I am long BP, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.