U.S. Markets close in 2 hrs 10 mins

# Is There An Opportunity With BP p.l.c.'s (LON:BP.) 22% Undervaluation?

Today we will run through one way of estimating the intrinsic value of BP p.l.c. (LON:BP.) by taking the foreast future cash flows of the company and discounting them back to today's value. I will be using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Want to participate in a short research study? Help shape the future of investing tools and you could win a \$250 gift card!

### Is BP fairly valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

#### 10-year free cash flow (FCF) forecast

 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 Levered FCF (\$, Millions) \$11.21k \$14.82k \$13.56k \$13.94k \$15.75k \$16.05k \$16.33k \$16.58k \$16.82k \$17.06k Growth Rate Estimate Source Analyst x16 Analyst x16 Analyst x9 Analyst x2 Analyst x2 Est @ 1.9% Est @ 1.7% Est @ 1.56% Est @ 1.46% Est @ 1.39% Present Value (\$, Millions) Discounted @ 9.3% \$10.26k \$12.41k \$10.38k \$9.77k \$10.10k \$9.41k \$8.76k \$8.14k \$7.55k \$7.01k

Present Value of 10-year Cash Flow (PVCF)= \$93.78b

"Est" = FCF growth rate estimated by Simply Wall St

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (1.2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 9.3%.

Terminal Value (TV) = FCF2029 Ã— (1 + g) Ã· (r â€“ g) = US\$17b Ã— (1 + 1.2%) Ã· (9.3% â€“ 1.2%) = US\$214b

Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = \$US\$214b Ã· ( 1 + 9.3%)10 = \$87.83b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is \$181.62b. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate in the companyâ€™s reported currency of \$8.93. However, BP.â€™s primary listing is in United Kingdom, and 1 share of BP. in USD represents 0.777 ( USD/ GBP) share of NYSE:BP, so the intrinsic value per share in GBP is Â£6.94. Relative to the current share price of Â£5.39, the company appears a touch undervalued at a 22% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

### Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at BP as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 9.3%, which is based on a levered beta of 1.214. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

### Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldnâ€™t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For BP, There are three essential factors you should look at:

1. Financial Health: Does BP. have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future Earnings: How does BP.'s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of BP.? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LON every day. If you want to find the calculation for other stocks just search here.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.