Essay Paper on BP PLC

by Jeffrey Sanders 

One of my clients, let us call him Mr B, is seeking an opportunity to increase his portfolio in a short term. He is asking me to choose a company for him. I think BP plc is the right company for him. £50,000 is the considerable sum, though, and I want to check the merits of the chosen company.

In three years, with annual inflation rate of 5% (average discount rate), this sum will be discounted and will roughly have the purchasing power that £45,000 have today.

The company I have chosen for him is BP plc. Its net income is more than 20 billion dollars a year for the past dozen of years, big business shares had the best figures. Though small business had even bigger figures, investing into big business is safe. Besides, investing into liquid is safe.

According to the same source, “Water may be one of the richest investment opportunities of the next few decades.” (Yahoo! Finance and The Week, 2006) But the first people who can benefit from it are not ordinary shareholders, but accredited ones who buy the shares before the IPO. For my client, investing into BP is recommended for his comfort and safety.

When you valuate a business, you look at its financial report and not on its share price at the moment. But with oil and gas, you must also have a look at the peculiarities of this industry. Let us first discuss share prices and financial figures in BP reports.

Share price

The share price today is 68.18 USD, or 577.5 GBP. BP shares were a bit behind the shares of other oil companies in 2006. Since a year ago, according to a comparative chart, share prices fell by 11% by the BP vs FTSE scale. This can be for different reasons. (BP plc web site)

Oil company valuations depend largely on the oil price policy. Additionally, fluctuations of the share market can be caused by the imbalances that are not related to the company’s activity. An intelligent investor must understand, though, that the current share value is not so important as the future one. With BP, there is no need to worry that in the future, oil prices fluctuations can affect BP Amoco. Its downstream sector is so diversified that future risks are brought to minimum.

Gordon Growth model and CAPM model

BP Amoco is one of the five companies with developed economies to which Gordon Growth model can be applied wholly. Other companies are vulnerable to oil price volatility and geological risks.

What are the future projections for BP Amoco? You must know that oil business demands more capitalization than any other business like trade, pharmaceuticals, or power. So, cash flow projections must embrace no less than ten years ahead. To assess the risk correctly, CAPM model is used along with Gordon Growth model. CAPM model allows one to assess BP’s rate of equity, which depends on risk-free rate and expected return of investor.

BP’s revenues are ten times more than the net income. This ratio is higher than usual due to the same reason that oil industry demands much capitalization. But this ratio is likely to diminish as the business spends less on research and capitalization, and is more concerned with sales and recycling.

Company valuation

For valuating a company either DCF or relative techniques can be used. “Over the years, surveys suggest that the use of DCF techniques as primary evaluation methods has increased significantly and non-DCF techniques often supplement DCF methods in capital budgeting” ( Shimin 1995). Calculating the company’s WACC by means of DCF method is more important than analysing its data separately. BP’s WACC is approximately 10 to 15% each year, this being twice or three times as much as the annual average inflation rate.

Looking at tables, you can see different ratios: price to earnings, price-to-book and price-to-free cash flow ratios.

“There is a large population of individual investors who stop their entire analysis of a company after they figure out the trailing P/E ratio.” – says a guide on relative valuation approaches. (Earnings Based Valuation)

Though the BP’s PE ratio is significant (above 16%), “companies have different operating philosophies and various levels of success.” (Finding the True Value Relative Valuation)

But, according to the same source, “valuation ratios such as the P/E and EV/EBIT metrics aren’t completely useless, as they can give you a feel for a company’s value, compared with this, that, or the other.” (Finding the True Value Relative Valuation)

EBITDA and P/E ratios are the highest for BP plc are among the highest comparing with other oil and gas companies.

Some invest in stocks “based on what yield they should have.” (Yield Based Valuation)

The same site says that Equity based valuation does not deserve any attention. It says that “investors who rely on buying companies with a substantial amount of equity to back up their value are a paranoid lot who are looking to be able to collect something in liquidation.” (Equity based valuation)

Certain investors look first at what is the overall cash flow of the company. “Why look at earnings before interest, taxes, depreciation and amortization? Interest income and expense, as well as taxes, are all tossed aside because cash flow is designed to focus on the operating business and not secondary costs or profits.” (Cash Flow Based Valuation)

It is a rare case when only revenues should be valuated. “New companies in hot industries are often priced based on multiples of revenues and not multiples of earnings.” – explains the guide for novices again. (Revenue Based Valuation)

Risk Relative Index

            According to Dow Jones Risk Relative Index, BP plc’s performance is 0.77% to 3.82 compared with the previous month. The relative risk for one year is 7.28% to 25.54% (conservative and aggressive portfolio index respectively). (Dow Jones Portfolio Indexes).

            When a team of researchers determined the RFR for BP, the company noted that they overestimated it in some periods and underestimated it in other periods. (Cost of Capital, 2005).

The current intrinsic value

The current intrinsic value of the company is to be calculated by using a DCF technique. An investor or an analyst should value the stock individually using the DCF valuation technique. He learns whether the stock is ‘overvalued’ and it exceeds its intrinsic value, or it is “undervalued,” and is below its intrinsic value. An investor who contemplates buying the company’s stock does not buy a stock that is trading at a price that we believe is above its value. An investor holding the stock, which exceeds its intrinsic value by more than 15% sells it and buys the stock that is below its intrinsic value. Then, the assumptions regarding the company’s revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement are made. It is difficult to make assumptions for BP because its has conquered markets in 70 countries of the world and owns a network of 29 000 petrol stations. In each country, a holding reports their own sales growth, revenues, EBITDA, and dividends per shares.

The history and a fact box

            In 2000, the company’s revenue grew by 77%, and the net income more than doubled that year. The growth rate has slowed down since that time, but “the party is not over yet.” (Kiyosaki, 2000). The company is using 3,2 million barrels of oil a day, while its resources are more than 19 billion barrels. BP is the biggest oil company after Exxon Mobil, and it’s the second largest public company. This is a low risk company for an investor.

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