It had been an encouraging year for shareholders in BP (LSE: BP) until the start of July. Indeed, the oil major’s share price had risen by 7% from the start of 2014 until that point; outpacing the FTSE 100, which was flat over the same time period.
However, further uncertainty surrounding Russian sanctions has weakened sentiment in BP so that shares are now down 3% year-to-date, which is clearly disappointing for investors in the company.
Despite this, BP remains a highly lucrative investment that could rise by 31%. Here’s why.
Growth Potential
Although BP’s earnings are set to remain highly volatile in the short term — they’re forecast to fall by 36% in the current year, for instance — BP’s asset base remains highly lucrative. Indeed, even after huge sell-offs of high-potential assets, in order to settle payments related to the Deepwater Horizon oil spill, BP continues to have a strong asset base that is forecast to start a period of growth next year, with an increase of 8% in the bottom line.
Certainly, 8% is not all that much more than the growth rate of the FTSE 100, but it’s a good start and shows that BP could start to deliver more predictable earnings growth going forward than it has done in recent years.
Valuation
Furthermore, the market does not yet seem to be pricing in improved, and more stable, prospects for BP. For example, even though the company is not particularly generous when it comes to paying out profits as a dividend — its dividend payout ratio is just 49% — BP still offers a yield of 5%. This is much higher than the FTSE 100’s yield of 3.6% and shows that BP could be undervalued at current price levels.
Indeed, were BP to increase its payout ratio to a still comfortable 65%, which is a realistic figure given the improved longer term prospects for the business and would still allow for the company to reinvest in its asset base, it would mean that shares trade on a yield of 6.6% at current prices.
Clearly, that is unlikely to happen, since investors are likely to bid up the price of BP’s shares as they are attracted by a high yield. Therefore, if BP were to continue to trade at a 5% yield, but with a higher payout ratio, its shares would be priced at around 620p. That’s 31% higher than the current price of 472p and could prove to be a realistic level over the medium term, as BP transitions into a more stable era where it can be more generous with regards to shareholder payouts.
Looking Ahead
Clearly, BP is still recovering from the Deepwater Horizon oil spill, but seems to be getting back to normality. While Russian sanctions have hit shares in the short term, it provides an opportunity to buy in at an even better price, with there now being 31% upside to a price that, given BP’s scope to increase its payout ratio due to increased stability, seems very realistic over the medium term.