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BP (LSE: BP) shares have gradually drifted off their 31 March one-year high of £6.09 over the past few weeks. This has reflected increased optimism over a peace deal being struck in the US-Iran conflict.
The drop has widened the gap between the current price and the one-year target of the 19 main analysts covering the stock. It has also increased the distance to the long-term ‘fair value’ of the share.
So, what sort of gains could we be looking at here?
What’s the short-term analysts’ target?
The consensus rating is that the stock is a Buy, with the average 12-month price target being £5.96. This represents a relatively modest 13% gain from the current level of £5.35. That would mean a £19,999 stake in the firm created today would be worth £22,660 in a year.
One of the three key reasons underpinning this bullish view is the firm’s refocusing on fossil fuels. BP has reduced its annual renewables investment to $1.5bn–$2bn to prioritise a target of 2.3m–2.5m barrels of oil equivalent per day by 2030. Fossil fuels deliver higher and quicker returns than renewables, which require heavy ongoing investment before profits are generated.
BP is also prioritising debt reduction and balance-sheet repair over riskier capital allocation. That places it in a great position to generate multi-billion-dollar free cash flows, supported by strong refining margins.
And finally, ongoing geopolitical tensions have raised the baseline for global oil and gas prices. This has further exacerbated BP’s very low forward price-to-earnings ratio compared to its peers. In fact, its 8.3 rating is bottom of this competitor group, which averages 12.5. The companies here include Shell at 8.6, Chevron at 13.4, ExxonMobil at 13.9, and Saudi Aramco at 14.
What’s the long-term fair value?
As a long-term investor, standard analysts’ price targets (which are 12 months out) are of little use to me. I am interested in where a stock might be in five, 10, 20 and even 30 years’ time.
To ascertain this, professional long-term investors commonly use discounted cash flow (DCF) analysis. This projects future cash flows for an underlying business and discounts them back to today. That produces a per-share price today, termed ‘fair value’.
The more uncertain those projections are, the higher the discount applied to them. Analysts’ different assumptions here can result in varied outcomes. Using my own DCF framework — including a 7.6% discount rate — BP shares are 61% undervalued at their present £5.26 price.
That implies a fair value of £13.49.
Historically, share prices tend to trade to their fair value over time. If that continued, then the £19,999 holding would be worth £51,289.
My investment view
One risk for BP is a multi-year period of low oil and gas prices that could not be fully counterbalanced by its oil and gas trading activities. Another is any further increase in taxes on fossil-fuel profits that would damage its cash flow.
Nevertheless, analysts forecast BP will grow its profits by an average of 9.5% a year over the medium term at least. And it is this that drives any company’s share price higher over time.
Consequently, I am using the current share price dip to buy more of the stock. And I also have my eye on even more undervalued shares that deliver high dividend income.
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Simon Watkins owns shares in BP.
This story originally appeared on Motley Fool
