Are BP shares undervalued?

Falling crude prices have been weighing on shares in oil companies since the start of the year. And more than one is trading in territory that I think should catch the attention of value investors. 

One of the most dramatic has been BP (LSE:BP) – after falling 23% since the beginning of January, the stock now has a dividend yield of more than 6%. But there are some things investors should know.

Valuation

On the face of it, BP is very similar to Shell (LSE:SHEL) – the other FTSE 100 oil major. For example, both trade at a price-to-earnings (P/E) ratio of around nine based on next year’s expected earnings. 

In addition, each has breakeven costs of around $60 per barrel. So as long as oil prices stay above that level – which they generally have since the pandemic – both companies remain profitable.

The two are also similar in terms of strategy. After an unsuccessful venture in renewables, BP has shifted its priorities back to hydrocarbons, which is where Shell has been focused. 

This makes it look as though there isn’t much difference between the two stocks. But there’s at least one significant difference that investors need to pay attention to.

Balance sheet

At this year’s Berkshire Hathaway shareholder meeting, Warren Buffett said that he spends more time looking at balance sheets than most investors. And with BP and Shell, this is quite revealing.

Shell has a debt-to-equity ratio of 0.4. That means the firm could clear all of its debt by increasing its share count by 40%. 

By contrast, BP has a debt-to-equity ratio of 1.2. Clearing its debt by issuing stock would therefore require the company to more than double its number of shares outstanding. 

A debt-to-equity ratio of 1.2 isn’t just higher than Shell, it’s high by BP’s historic standards. It’s even higher than it was during the Covid-19 pandemic and this is a significant risk.

Investing in oil companies

Falling oil prices have been weighing on energy stocks, but I actually think the lower prices make this a decent time to consider buying. The question is whether BP is the most attractive opportunity.

As I see it, the company’s balance sheet is the biggest risk with the stock right now. And the firm is making moves to try and reduce its debt levels via cost savings and divestitures.

The trouble is, I’m not convinced that right now is a good time for oil companies to be selling assets. When prices are low, it’s better to be a buyer than a seller. 

As a result, I don’t see BP shares as undervalued – at least, not relative to other oil companies. I’m not against the industry as a whole, but I think there are better opportunities to consider elsewhere.

Activism

It’s worth noting that there is an activist investor on board at BP. Elliott Management became a major shareholder earlier this year and is pushing for reform. 

This could generate strong returns. But with lower oil prices weighing on energy shares across the board, I’m looking elsewhere in the oil and gas sector for my own portfolio.

The post Are BP shares undervalued? appeared first on The Motley Fool UK.

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Stephen Wright has positions in Berkshire Hathaway. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.