In the past month the share price of British Petroleum's stock (Ticker:BP
) has taken a massive beating. The stock is down 35% in the past month. In the past five days alone the stock is down 20%.
The question is, is the stock overvalued or undervalued? There are good arguments on both sides, but I think this is a classic case of investor overreaction, and the stock is a good buy.
James Altucher wrote a column in the Wall Street Journal recently examining the question of British Petroleum's potential liabilities due to the recent oil spill. He believes in a worst case scenario the company would be liable up to $40 billion. In addition, there are several unknown factors that could weigh negatively on BP. What action will the Government take to curtail offshore drilling? BP's reputation has been severly damaged, will this hurt future profitability? Both these questions cannot be quantitatively measured, and only time will tell the answer.
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Some people are far even more pessimistic than Altucher. There are uncertainties as to how high the liabilities of BP will truly reach. A recent news report stated that BP may be forced to declare bankruptcy.
Despite these uncertainties there is a strong bullish case to be made. It seems investors are assuming the worst- that BP will be on the hook for tens of billions of dollars. Even, if this happens BP should be a safe investment, since BP is a cash machine. BP had $7 in free cash flow last quarter. BP's cash flow from operations in 2009 was $28 billion. The company also has $8 billion of cash on it's balance sheet, and total current assets are close to $70 billion.
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Altucher points out in his article despite the media's obsession with BP; Halliburton (HAL), Cameron (CAM), Transocean (RIG) are also going to be liable in part. He states that it may be years before it can be ascertained which party is guilty. Altucher also states that BP has insurance which will cover some of the costs.
BP is currently trading at $32 per share. Next years earnings are estimated to be approximately $7.4 per share. If we take a conservative multiple of 12x earnings, BP should be worth around $90 a share. $90 per share would representative approximately a 300% return on investment. In addition, BP has a fat dividend of approximately 10%( I must note though, there is a good chance BP will cut or completely eliminate the dividend).
On the other hand there is the chance the company will go bankrupt. I think this possibility is remote. But let's assume assume the chances are 50/50. The stock would have an upside of nearly 300% and a downside of 100%. This would still make the stock an impressive investment. I believe based on this fact BP is a risky, yet attractive investment. There is no margin of safety here, but the risk/reward ratio is very high.
Disclosure: Long BP