Is It Time to Buy BP plc?

^{A version of this article originally appeared on Fool.com}

WASHINGTON, DC — BP (LSE: BP) (NYSE: BP.US) still faces uncertainty around its 2010 Gulf of Mexico oil spill lawsuits. Despite this uncertainty, the company’s stock is slowly recovering. Even if BP ends up paying much more than it had initially estimated for the plaintiffs of the oil spill-related lawsuits, is the company’s current price still a bargain?

Oil spill lawsuits

It’s still unclear how the Deepwater Horizon oil spill lawsuit will end for BP. Up to now, the Fifth Circuit Court hasn’t approved BP’s efforts to ward off claimants whose alleged injuries were not a direct result of the 2010 oil spill. BP didn’t account for this provision and could wind up paying much more than it had initially estimated. But there is also a chance, which currently doesn’t seem too high, that BP’s lawyers will succeed in preventing BP from paying BEL claims. The main issue is how high the market currently values BP compared to its peers, which don’t have such uncertainty hovering over their heads.  

Does BP measure up to other oil companies?

Let’s see how BP is priced compared to other top-tier oil companies such as ExxonMobil (NYSE: XOM.US) and Chevron  (NYSE: CVX.US) . BP’s current market value is around $156 billion, and its P/E is relatively high at 15.8. In comparison, Chevron’s P/E is only 12.1. But this measurement doesn’t account for the level of debt or cash on hand, and it considers net earnings rather than operational profits. If we were to use the enterprise value-to-EBITDA ratio, then BP’s ratio is at about 5.8; this is much lower than the current ratios of ExxonMobil and Chevron as indicated in the table below.

Source of Data: Yahoo! Finance

Moreover, the current oil and gas average EV-to-EBITDA ratio is around 6.5. If BP’s value was increased to this average, assuming all else equal, the company’s market cap would reach more than $180 billion. The table below shows the gap difference between the two valuations.

Source of Data: Yahoo! Finance

Based on a market cap of $180 billion, the company’s stock should have been $57-plus rather than $50.

This means, under these assumptions, BP’s valuation is off by $23 billion. In other words, if most of BP’s undervaluation comes from the oil spill lawsuits, the market currently estimates the potential loss in value by $23 billion.

This brings us to the second question: What is the value of the uncertainty around the claims for economic loss?

Until year-end 2013, the company spent $12.8 billion on economic recovery and committed $2.3 billion to economic loss of claims. It also paid under the plaintiffs’ steering committee settlements $2.7 billion. In total, the company allocated $42.7 billion toward all out-of-pocket and spill-related expenses, including government penalties. Currently, the company estimates the economic loss claims will reach $9.2 billion — a higher figure than initially estimated.

Even if we were to consider a worst-case scenario, the company winds up paying $10 billion more than its initial estimates; this doesn’t come close to the $23 lower value the market currently puts on shares of BP. Moreover, the company has already allocated a significant amount of assets toward paying potential additional claims (BP plans to divest $10 billion worth of assets by year-end 2015.) Thus, it seems the market still estimates the company’s future settlements at a higher price than what BP may wind up paying.

In conclusion…

The oil spill settlement is likely to keep curbing BP’s rally. But the current market estimates still seem to undervalue BP’s stock, which should be 5% to 10% higher than its current price.